Theresa at In The Game Investing has written this great post looking at the Mega Backdoor Roth. Tim
The Mega Backdoor Roth takes investing in a traditional 401(k) to the next level for high-income earners. If you meet the eligibility requirements, you could stash an extra $41,500 for retirement in a Roth IRA. However, it’s complicated, and mistakes can be costly.
Although the mega option is similar to the backdoor Roth IRA, they’re two distinct accounts. Even though they’re both designed for high-income earners to convert a traditional IRA fund to a Roth, they do things differently.
The backdoor option was designed for high-income earners to make a regular Roth contribution using tax-deferred earnings. In contrast, the mega backdoor Roth IRA was designed for after-tax contributions to a 401(k) to convert to a Roth IRA.
You could call the mega backdoor option mega as it offers a more considerable after-tax contribution into a Roth IRA. However, it’s not for everyone. The choice comes with a few limitations. Nevertheless, it works great for some. So, it’s worth learning about it. In this article, we’ll talk about the basic rules of a Mega Backdoor Roth to see how it works in 2022.
What Is an Individual Retirement Account (IRA)?
An individual retirement account (IRA) is a savings and investment account with tax advantages. A traditional IRA uses pre-taxed dollars, while a Roth IRA uses after-tax dollars. As a result, they both have tax savings, either now or later.
You can open an IRA through a bank, investment brokerage, or employer. Through employers, IRAs are 401k, Roth 401k, 403b, Roth 403b, Thrift Savings Plan, or SEP (Simplified employee pension).
IRAs are used to purchase stocks, bonds, mutual funds, target-date funds, exchange-traded funds, and more. Employer-sponsored plans may have limited choices. However, many offer employer-matching contributions.
Because of the tax advantages, IRAs are for retirement. They incur a 10% early withdrawal penalty, but it’s waivable in situations like financial hardships, first-time homebuyers, certain education expenses. Traditional IRA accounts will have to pay taxes on the withdrawal in addition to the penalty.
Roth IRA Versus Traditional IRA
A Roth IRA is an individual retirement account (IRA) funded with after-tax dollars. It allows funds to grow over time without incurring taxes on the profits. In other words, withdrawals aren’t taxed during retirement, leaving more money in the pockets of retirees.
Unfortunately, high-income earners can’t directly contribute to a Roth IRA. Maximum contributions are limited to individuals who earn less than $129,000 (single) and $204,000 (married). After that, contributions are phased out for individuals earning more than $144,000 (single) and $214,000 (married filing jointly).
The traditional IRA offers an upfront tax deduction on contributions with taxable withdrawals during retirement. However, It doesn’t come with income limits.
Both types of IRAs come with contribution limits. For 2022, the combined annual contribution limit is $6,000 for individuals under 50 years of age and $7,000 for individuals age 50 or older.
Although both types of IRAs come with similar contribution limits, high-income earners lose out on tax-free growth that comes with a Roth IRA. Yet, they do have another option: the backdoor Roth IRA.
Backdoor Roth IRA
The backdoor Roth IRA allows high-income earners to transfer funds from a traditional IRA to a Roth IRA. Individuals must pay taxes on the money that is transferred (since they didn’t pay taxes on the original contribution) and may transfer up to the maximum $6,000 contribution limit for individuals younger than 50 years of age ($7,000 for those over 50 years of age).
Here’s are the basics to follow:
- No other pre-tax IRA accounts. Ensure that you don’t already have a large IRA account, including a 401(k) from a previous employer.
- Contribute to a traditional IRA. Establish a traditional IRA. Contribute tax-deferred earnings up to $6,000 ($7,000 for individuals age 50 or older).
- Convert the traditional IRA to a Roth IRA. Unlike contributions, conversions don’t have income limitations. You can transfer up to $7,000 (depending on your age) from your traditional IRA to a Roth IRA in a given calendar year.
It’s important to note that traditional IRA contributions use tax-deferred income. If you want to make after-tax contributions, look into a mega backdoor Roth IRA.
Mega Backdoor Roth IRA
The Mega Backdoor Roth IRA allows you to supercharge your investments. After maximizing your contributions to a traditional 401(k) ($19,500 for anyone under age 50, $25,000 for anyone over age 50), you can contribute after-tax dollars up to the annual maximum (employee and employer-match) contribution if your employer plan allows it. That’s an additional $41,500 in a Roth IRA with after-tax dollars ($48,000 for those over age 50).
The Mega Backdoor Roth IRA is complicated. However, here are the basic principles:
- Your company must offer the option to make after-tax contributions to your 401(k).
- Your company must allow your 401(k) conversions to a Roth IRA.
- You have to max out your traditional 401(k) contributions.
- You have the funds available to contribute additional money to your 401(k).
Benefits of a Mega Backdoor Roth IRA
The Mega Backdoor Roth IRA has benefits for the right person. Here are a few:
- It can rapidly increase overall retirement savings rates. After maximizing their annual contribution limits, individuals investing in their 401(k) save more than $20K a year for retirement. Compounded, this leads to rapid growth. At an annual rate of return of 10%, a $25,000 monthly investment can grow to more than $1.9 million in 5 years.
- The Mega Backdoor Roth IRA allows for significant tax-deferred growth when done correctly. The result is significant tax savings.
Cons of the Mega Backdoor Roth IRA
The Mega Backdoor option isn’t without cons. Take a look at this list for more details:
- It’s not easy to contribute beyond the tax-deferred contributions. The $20,500 maximum contribution equates to $1,708 a month (the max contribution rises $6,500 for those age 50 or over). It’s a high rate of savings. To benefit from the mega backdoor Roth IRA, you would be saving at a rate higher than this.
- Not all employers offer Rollover Roth IRA options. Despite a few incredible benefits, not everyone will qualify for a mega backdoor Roth IRA due to their employer.
- Regulations may change. Lawmakers are talking about changing contributions and withdrawal limits for high-earners contributing to Roth IRAs. It’s worth following if you’re considering this option.
- Withdrawals are subject to the Pro-Rata Rule. The pro-rata rule says your withdrawals must be equal to the ratio of your contributions. So in some cases, you may end up paying more taxes than if you put the money in a Roth IRA from the start.
The IRS views your IRA as one big pot. Therefore, the percent of tax-free distribution equals total after-tax contributions divided by the entire balance of the IRA.
For example, you have $100,000 in a traditional tax-deferred IRA and $50,000 in a rollover Roth IRA. The IRS will assume that your withdrawals came from both accounts at the rate of your original contributions. Therefore, 50% of the $50,000 ($25,000) in your rollover Roth IRA will not be taxed, and 50% ($25,000) will be taxed.
It can be hard to determine your tax bracket using the mega backdoor Roth IRA. You may need to contact a financial advisor and tax advisor for help.
Who’s Eligible for a Mega Backdoor Roth?
Individuals investing in a Mega Backdoor Roth IRA earn more than $144,000 annually (the max income for a Roth IRA for singles, $214,000 married filing jointly). They must have sufficient income to pay their expenses while investing more than $20,500 in their traditional employer-sponsored 401(k) plan. In addition, they must work for a company that allows after-tax contributions and Roth rollovers.
Alternatives to the Mega Backdoor Roth
The Mega Backdoor Roth isn’t for everyone. That’s Ok. With strong money habits, anyone can become a millionaire. While looking to move to a higher-income job work you can:
- Increase your financial literacy
- Get your finances together
- Start a budget
- Learn to pay yourself first
- Cut expenses
- Minimize bad debt
When you’re ready to start investing, you may find the following options helpful:
- Traditional 401(k) or Roth 401(k) through your employer
- Thrift Savings Plan or SEP plans through eligible employers
- Health Savings Account
- Traditional or Roth IRA with an online investment broker
- Robo investing with automatic savings
- Taxable brokerage account
The Bottom Line
The Mega Backdoor Roth IRA is a mega-savings option for high-income earners. It opens the doors to high savings rates and significant tax savings over time.
However, this option is complicated. Individuals will need to weigh the pros and cons or consider working with a financial advisor or tax advisor for help.
Building wealth takes time. There are alternatives to the mega backdoor Roth. So, invest early and invest often with dollar-cost averaging.
Disclosure: The author is not a licensed or registered investment adviser or broker/dealer. They are not providing you with individual investment advice. Please consult with a licensed investment professional before you invest your money.
Learn how to diversify and hedge your long-only stock portfolio. Sign up for a free insight into the Swing Trading 101 program developed over thousands of hours of trading over hundreds of thousands of dollars across stock, commodities, options, and cryptocurrencies. It’s designed to empower you to take a unique but strategic approach to the markets. Learn More.
Tim Thomas has no positions in the stocks, ETFs or commodities mentioned.
Featured image credit: Pixabay.