If you understand and like the benefits of a Backdoor Roth style investment account, then you’re likely also going to like its big brother, the Mega Backdoor Roth. If you are not familiar with it, it's a good idea to understand it to see whether it can work for you as you plan for your retirement.
In a Roth IRA, money is contributed after paying income tax on it. These dollars grow tax deferred and as long as you follow all of the IRS regulations the contributions as well as the earnings. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. For 2020, contribution limits apply: up to $6,000 per year if you’re under 50 and if you are over 50 the $1,000 catch up contribution applies making your annual contribution $7,000. To be eligible for contribution you must meet the IRS eligibility requirements, one of which is earned income for the year. Although too much income also makes you ineligible...queue the Backdoor Roth IRA.
The Backdoor Roth IRA
A Backdoor Roth is a strategy for people whose income is too high to be eligible to directly contribute to a Roth IRA. With a Backdoor Roth, you make a non-deductible IRA contribution into a Traditional IRA and then, within the same year, convert all or a portion of that money to a Roth IRA. Modified Adjusted Gross Income (AGI) levels dictate whether you can directly contribute into a Roth IRA or you are phased out and ineligible for direct contribution. For individuals filing single your phase out is an AGI of $124,000 to 139,000, for couples filing jointly your phase out is an AGI of $196,000 to $206,000. If you are above these thresholds, a Backdoor Roth could be an investment strategy for you. This is allowed as there are no income limits on IRA conversions.
(*There can however be tax implications to this and you should consult with a tax advisor on this subject prior to doing it.)
A mega backdoor Roth takes this concept to a larger scale.
What is it Exactly, and How Does it Work?
A Mega backdoor Roth is also a complex investment strategy, not suited for everyone. Please consult with a tax professional prior to deciding.
“A mega backdoor Roth offers the opportunity for some investors to contribute up to an extra $37,000 for 2019 to a Roth IRA via their employer's 401(k), if the 401(k) allows for after-tax contributions over and above the employee contribution limits. These limits are $19,000 for 2019 and $25,000 for those who are 50 or over. The limits for 2020 will be $19,500 and $26,000, respectively,” explains The Street.
The main benefit is that a mega backdoor Roth allows for up to an additional saving of $37,500 in a Roth IRA or Roth 401(k) in 2020. That on top of the regular contribution limits for those accounts.
So, it should go without saying, but a mega backdoor Roth IRA is a great way to save a lot of money into a Roth style of account, but ultimately you have to be one of those lucky enough to be able to save that amount of money each year as well. That means that you are under 50 and have already saved $25,500 ($19,500 into your 401k plus the $6,000 into your Roth IRA (either directly or by conversion), and if you are over 50 you already saved $33,000 ($26,000) into your 401K plus $7,000 to your Roth IRA (direct or by conversion) for the year 2020.
Do You Meet the Criteria?
If you have successfully saved that much, you need to do some homework and examine your 401(k) to see if the plan has the right things in place for a Mega Roth. Check with your 401(k)plan sponsor or administrator for more details. In particular, you will need to find out two things.
The first is that your 401(k) plan allows for “after-tax contributions”. This is a separate third pool of money inside your 401(k) that is different from your Traditional and Roth 401(k) contributions.
Second, the 401(k) plan permits either in-service distribution to your Roth IRA or lets you move money from that “after-tax contributions” third pool of money into your Roth contributions pool inside your plan. If your plan does not offer a Roth option you only recourse would be an in-service distribution to a Roth IRA.
This is a complex matter involving not only IRS, IRA and conversion regulations but also 401(k) regulations. Please consult your tax advisor prior to making any decision. After tax contributions can accumulate earnings that can have tax implications and should be closely examined.
So You Meet The Criteria, Now What?
Alright, so far so good, your 401k plan allows for all of that as well. Now what?
Now we need to figure out the math of how much you can put into the after-tax contribution pool within your 401(k).
To start, the maximum for 2020 that you and your employer combined can put into your 401(k) plan is $57,000, or $63,500 if you’re age 50 or older. To calculate the amount, you can put into the plan’s after-tax portion this year, subtract your 401(k) contributions and your employer’s matching contributions from that maximum. The remaining figure is the amount you can put into that after-tax portion of within your 401(k).
Here is an example. Let’s say you’re under 50, earn $100,000, and you max out your 401(k) for the year at a contribution of $19,500. Let’s also assume your employer matches your contributions 100%, up to 4% of your salary, so their match is $4,000 this year. The maximum amount you can put in the after-tax portion of your plan this year is $57,000 minus $19,500 minus $4,000, or $33,500.
If your employer doesn’t provide any match for you, you would be eligible to contribute the full amount of $37,500 into that after-tax bucket.
For more guidance on complex financial planning topics or to see if this investment strategy might work for you contact us today for a no cost no obligation consultation.
*The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.