Debt vs physician on fire backdoor Roth

Pay off Debt vs. Backdoor Roth?

Backdoor Roth vs. Pay Off Debt

When you first start out, money is tight!

Let’s look at planning software and compare if you should pay off debts as quickly a possible or invest in a backdoor Roth IRA.

Debt vs. the Physician on Fire backdoor Roth!

Both are made with after-tax money. When you pay off your debt, you guarantee return on investment. Backdoor Roth contributions, on the other hand, grow tax-free but have investment risk.

Roth space is precious! There is only so much you can get every year. After you have half an emergency fund, you might want to fill out the rest of your emergency fund with a backdoor Roth IRA.

But after that… being debt free is sweet, but at what cost? Should you lose the space in your Roth in order to pay down debt?

Let’s look at a fictional family who either pays off debt or does backdoor Roths… how do the numbers play out over 10, 20, and 30 years?

Assumptions Debt Vs Backdoor Roth

Assume a couple are both 33 years old and make $250,000 a year.

They contribute 6% to a 401k with a 6% match. In addition, they have a small brokerage account and have started Backdoor Roth contributions. They plan to invest $5000 a year in a 529 plan if there is sufficient cash flow.

Let’s look at their loans.

Loan APR Minimum Payment Loan Balance Term
Car 3% 195 25,000 10y
Student 5% 1591 150,000 10y
Mortgage 4.5% 1968 400,000 30y

Table 1 (Loans)

They have a car loan, refinanced private student debt, and a zero-down (“Doctor”) home mortgage. Minimum monthly debt service is $3,754.

Debt Plan vs. Roth Plan

Let’s compare two scenarios.

First- what about aggressively paying down debt with an extra $2000 a month above the minimum payments, or $24,000 extra a year? Let’s call this the Debt Plan.

Or, consider the Roth Plan. Here, they will put away $12,000 a year in backdoor Roth IRAs and the rest will be invested in the brokerage account and 529 plan. They pay minimum debt amounts monthly.

So, which plan do you pick to come out ahead? Seriously, stop now and choose!

Balance of Debt

Pay off debt vs physician on fire backdoor roth

Figure 1 (Debt over Time)

Above, debt for the two plans. In the Roth Plan (dark blue), student and car loans are paid over 10 years, and the mortgage takes 30 years. The Debt Plan (teal) pays off all debts 19 years earlier, saving almost $214,000 in interest payments over 30 years.

Invested Assets

roth IRA vs pay off debt

Figure 2 (invested assets)

Above, see the invested assets for the Roth Plan (light green) and for the Debt Plan (darker blue). Clearly, you get a head start investing aggressively, but over 25 years the Debt Plan catches up.

Net Worth

back door roth debt payment

Figure 3 (net worth)

Net worth for both of the plans start negative. Both plans reach zero at year six and they are millionaires after working for 15 years!

Breakdown of Cashflows

Plan Year Debt payment Brokerage Roth 529 Net Worth
2020 69 21 15 0 -462
2022 69 23 19 0 -295
2024 69 25 23 0 -114
2026 69 19 26 0 73
2028 69 3 27 0 268
2030 24 18 41 5 473
2035 0 235 113 37 1,057
2040 0 454 200 77 1,727
2045 0 673 304 126 2,496
2050 0 893 427 186 3,386
2020 45 31 24 5 -462
2022 45 51 51 16 -297
2024 45 71 79 27 -119
2026 45 83 109 39 64
2028 45 89 142 48 253
2030 26 111 177 61 456
2035 23 212 276 103 1,026
2040 23 301 394 156 1,666
2045 23 371 536 219 2,451
2050 0 459 705 281 3,346

Table 2 (cash flows in thousands of dollars)

Cash Flows

Let’s check out the cash flows for each plan in more detail. Every second year is shown for the first decade, and then every 5 years out to 30 years total. Cash flows are shown in thousands of dollars.

Debt payments are listed first. They are $69,000 a year for a decade in the Debt Plan. In the Roth Plan, debts are $45,000 for the first decade, and then $23,000 a year for the next 20 years.

The brokerage account is actually spent down initially in the Debt Plan, but rapidly recovers and overtakes the Roth Plan in the second and third decade of the plan.

Next, the Roth account is underfunded while the Debt Plan pays off debt. It never has time to recover and is only 12.6% of the total net worth at 30 years in the Debt Plan, vs 21% in the Roth Plan.

The 529 also is unfunded in the early years of the Debt Plan.

Net worth for both plans is about the same at 10, 20 and 30 years.

The Results Are In

So, how is it that the Roth Plan did not perform better than the Debt Plan when conventional wisdom suggests investment returns beat payment of debt? Certainly, assumptions of interest rates on the fictional debts and 6% return on stocks affect the results, and different assumptions will generate different results.

However, remember the FIRE dictum that early on, savings rate matters more than investment return. With the 401k match, and including servicing of debt, they have approximately a 50% savings rate. They can manage this impressive saving rate despite living expenses of $100,000 a year and $60,000 a year in taxes.

Over time, as salary inflation is 1% and general inflation is assumed to be 2%, savings rate decreases to “only” 20%. This tremendously high saving rate overwhelms any difference between interest rates and return on investments. Specifically, the higher returns when investing take decades to compound, and the rapid debt payoff affords the Debt Plan to get debt free while still investing.

Savings Rate

If you have a high savings rate, initial investment returns don’t matter as much. The conclusion: rapidly paying off debt down is as good as investing. Of course, it is nice to have that extra Roth money which is tax-free, so when considering after-tax net worth, there is an advantage to the Roth plan.

So, Pay off Debt or Physician on Fire Backdoor Roth IRA?

Pay off debt or invest for the future? If you could predict the future, you would know the sequence of returns of the stock market, and invest when the market is down and pay debt off when it is high.

Short of having a crystal ball, a high savings rate allows you to do both and reach financial independence rapidly, free from debt and ready to take advantage of the magic of compounding interest.

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  1. There are too many assumptions to make this really helpful.
    If investment returns are high relative to interest rates the Roth will overwhelm.
    More important, depending on final net worth the Roth gives much more flexibility and potentially lower marginal tax rates in retirement

    • There are too many assumptions to make any modeling useful. This was my second or third blog I ever wrote. Be gentle!

  2. This calculation has taken the couple to age 63. Since the Roth should be the last place that money is withdrawn, and since it is growing tax-free, things will be strongly in favor of the larger Roth plan by age 83. Also, I believe the tax deduction of the mortgage payments is substantial. Was that included?

    • Mortgage deduction is less than people think (and most couples don’t even get it at all right now). By product of the mortgage industry selling mortgages is the idea that you can write off the interest. It is always nice to have Roth money!

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