By: Joseph Goldy, AAMS®
Roth IRA
For many people utilizing a Roth IRA to help save for retirement, they enjoy the benefits of tax-free growth and tax-free withdrawals after the age of 59 ½. An additional advantage of the Roth IRA, in contrast to a Traditional IRA, is that you are not required to take minimum withdrawals at age 72, enabling the account to continue to grow tax-free.
Who Qualifies for a Roth IRA?
However, there are some limitations on who can participate in a Roth IRA and its potential tax-free benefits. For 2021, single filers earning more than $140,000 will generally not be able to contribute, and joint filers earning more than $208,000 are also over the income ceiling.
Backdoor Roth IRA
A popular strategy has been to utilize a backdoor Roth IRA contribution to legally circumvent the income thresholds.
Essentially, with a backdoor Roth IRA contribution, you are establishing a Traditional IRA and Roth IRA at your financial institution. You then make an after-tax non-deductible contribution, up to the $6,000 maximum, into the Traditional IRA and then immediately convert that amount into the Roth IRA. (Doing this correctly to avoid unnecessary tax implications involves ensuring you do not violate the IRS Pro-Rata Rule, among other things. Please speak with your wealth advisor and tax professional before executing this strategy.)
Mega Backdoor Roth IRA
The “Mega” version of this backdoor Roth conversion involves utilizing your 401(k) since it allows much more significant potential contributions, taking the backdoor conversion strategy to the next level.
A Mega backdoor Roth could potentially work well in certain specific situations, but not all. For example, some who may benefit are generally maxing out their 401(k) contributions each year and utilizing other savings vehicles such as HSAs and regular Roth IRA contributions. Additionally, to use the Mega strategy, a person’s 401(k) will need to allow for both in-service withdrawals and after-tax contributions.
If you find yourself meeting the criteria, here is how a Mega backdoor Roth conversion would work with our fictional investor Sam.
Example of a Mega Backdoor Roth IRA
The maximum contribution in 2021 to your 401(k) is $58,000, comprised of the employee elective deferral amount of $19,500 and the $38,500 employer contribution maximum. Suppose Sam is maxing out his regular pre-tax contribution of $19,500 to his 401(k) via salary deferrals and is looking for additional savings. In that case, he can then potentially make an after-tax contribution into his plan up to $38,500 ($58,000 IRS annual plan maximum - $19,500 Sam’s salary deferral = $38,500 left for after-tax contributions).
Sam would then immediately convert the $38,500 additional after-tax contribution to a Roth 401(k) (if available through his employer) or a Roth IRA established at an outside financial firm. Instead of the usual $6,000 backdoor Roth IRA conversion limit, Sam just increased that to $38,500.
Some important things to note regarding this example. If Sam’s employer was also making employer matching elective contributions to his plan, that would reduce the amount he would be able to contribute to the after-tax portion of the 401(k). Also, as mentioned previously, not every 401(k) will offer a Roth 401(k) option. If not, Sam can still accomplish the strategy, but he would have to convert the after-tax contribution portion to a Roth IRA rather than a Roth 401(k).
Lastly, if you are self-employed and utilizing a solo 401(k), you would want to ensure your plan is created to allow both after-tax contributions and in-service withdrawals. However, if you design your qualified plan correctly, you can take advantage of the Mega backdoor Roth strategy.
Mega Backdoor Roth IRA for Self-Employed
For self-employed individuals looking to save above and beyond their elective deferral amount plus their profit-sharing portion, the Mega backdoor strategy allows them to contribute that extra amount, up to the maximum of $58,000. This strategy could be a potentially great way to get a significant amount into a Roth IRA and benefit from tax-free growth.
This strategy is not for everyone and has many moving parts. If something is done incorrectly, a negative tax consequence can negate any potential benefits you may get from the potential tax-free growth of the Roth IRA.
Working closely with your tax professional and wealth advisor will help to ensure the plan is executed correctly. Checking with your human resources department or plan administrator is also necessary to ensure after-tax contributions along with in-service withdrawals are possible with your plan.
Despite the hurdles necessary to benefit from this strategy, if you find yourself in the fortunate position of maxing out your current retirement vehicle options, the Mega backdoor Roth could provide a nice boost to your overall retirement strategy with further tax-free growth.
Author’s Bio
Joseph Goldy, CFP®, is a wealth advisor and CERTIFIED FINANCIAL PLANNER™ at Highland Financial Advisors, LLC, a fee-only fiduciary wealth advisory firm based in Wayne, New Jersey.
Joe specializes in working with newly independent women because of divorce or losing a spouse. He understands firsthand the value of having a clear financial picture pre- and post-divorce and a plan to restate goals as a single person. When he is not helping clients, Joe enjoys spending time with his two sons outdoors and volunteering to help raise money for Type 1 diabetes organizations.