Most people want to maximize the money they stash away for retirement, but the IRS limits how much you can place into your retirement accounts each year.
What do you do when you want to save more than that and still get the tax benefits? Is it even possible?
Utilizing a Mega Backdoor Roth, you can potentially stash away as much as $46,000 extra into your Roth IRA or 401(k).
So, what is a mega backdoor Roth, and how does it work? We’ll tell you everything you need to know about them so that you can take advantage of one if needed and maximize your retirement savings.
Basic Roth Retirement Account Rules
Before fully understanding how a mega backdoor Roth works, you must know the basics of Roth accounts.
With traditional retirement accounts, you contribute money to the account on a pre-tax basis. This means that your taxable income in the current year is lower, but you pay income taxes when you withdraw.
However, a Roth account is just the opposite. With a Roth account, you make after-tax contributions to your account. The taxes are paid on that income in the current year, and then that money is placed into the account.
When withdrawals are made at retirement age, they are tax-free. Everybody loves tax-free money, but not everyone can participate in every Roth option. Let’s compare a Roth IRA to a Roth 401(k).
Roth 401(k)
If your employer offers a Roth 401k option, anyone can participate regardless of income. The same contribution limits apply to a Roth 401(k) that apply to a traditional 401(k). You can only place $23,000 into your 401(k) account in 2024.
Your employer can also make matching contributions, although your employer match will usually go into a traditional 401(k) since no taxes have been paid on those dollars.
When you make qualified withdrawals at retirement from your Roth account, then you pay no taxes on those withdrawals.
Roth IRA
Like a traditional IRA, Roth IRA contributions are limited to $7,000 annually. This amount increases to $8,000 for those age 50 and older.
However, not everyone is eligible to participate in a Roth IRA. You might have too much income to be eligible, as high-income earners cannot participate in these retirement plans due to the IRS income limits.
If you are a single filer with an adjusted gross income of more than $161,000, the IRS does not allow you to contribute to a Roth IRA. Similarly, married couples with an adjusted gross income of over $240,000 cannot contribute.
KEY TAKEAWAYS
- A Mega Backdoor Roth is a strategy high-earners use to fund Roth accounts by converting after-tax contributions to a 401(k) into a Roth account.
- To apply the strategy, you must ensure that your 401(k) plan allows for in-service distributions or conversions. If it does not, then the Mega Backdoor Roth won’t work.
- You could fund a Roth account with over $60,000 each year if done correctly.
What Is A Backdoor Roth IRA
Now that you know the basics of Roth accounts, we will discuss the basics of a backdoor Roth.
If your income is too high to participate in a Roth IRA, there is still a way that you can get money into this type of account. Hence, the backdoor Roth IRA account. Regarding retirement planning, this can be a great tool to grow your retirement savings and take advantage of lower tax bills during your retirement years.
Remember that the basic difference between a Roth IRA vs traditional IRA is the timing of the taxes. Here is how a basic backdoor Roth IRA works.
- You need to have the money in a non-Roth IRA. This can be done by directly depositing into the account or performing a rollover from your 401(k). Remember that the IRA contribution limits still apply here.
The maximum contribution you can make to this IRA is $7,000. If you need to put more than this into a Roth account, you will want to use the mega backdoor Roth strategy, but we will discuss that next.
- After you have the money in a traditional IRA, you must perform a rollover to a Roth IRA.
Anyone can perform a rollover from a traditional IRA to a Roth IRA regardless of income, so you can get this money into a Roth account even if you are a high earner.
When you roll the money into the Roth account, you must pay income taxes on those dollars. Try to move the funds as quickly as possible because if they grow inside the traditional IRA, you will owe capital gains taxes on that growth!
- Once the rollover has been performed and the income taxes paid, your Roth IRA is done, and you can later take tax-free withdrawals.
This can lead to significant tax savings during retirement! Most brokerages can assist with this process and set up your accounts, like the Vanguard backdoor Roth.
Must read articles related to Retirement
- Which are the best states to retire?
- Leveraging a Backdoor Roth IRA strategy to reduce taxes in retirement.
- A guide to understanding Profit Sharing plans.
- How does a Solo 401(k) benefit self-employed business owners?
- Should you participate in a cash balance plan?
How Does A Mega Backdoor Roth Work
The Mega Backdoor Roth IRA allows you to save a large sum of money in a Roth account, but this strategy is only available to a few people.
It allows you to put up to $46,000 into a Roth account even if you exceed the generally applicable income limits.
Here is how it works:
- First, you must ensure you have maxed out your employee and employer contributions to your 401(k). Otherwise, this strategy doesn’t make much sense, as you will see no real tax benefits.
In 2024, you should have contributed a maximum of $23,000 to your account, and your employer can contribute up to $46,000.
- If you are 50 or older, you can also make catch-up contributions of $7,500. Some plans also allow you to contribute additional after-tax dollars.
Per the IRS, the $23,000 limit is the most tax-deferred money you can put into the plan.
If you contribute after-tax dollars to your account once you max out your pre-tax contributions, any gains associated with the after-tax contributions will be taxed upon withdrawal. However, as you know, Roth account withdrawals are tax-free.
- Next, your 401(k) plan must allow in-service withdrawals. Once you place the after-tax dollars into the 401(k), you should perform an in-service withdrawal and roll the funds into a Roth 401(k) or IRA.
Now that you have maxed out your regular 401(k) contributions, you have also funded your Roth account with a large sum.
4 Steps To Perform A Mega Backdoor Roth IRA Conversion
Now that you understand how a mega backdoor Roth conversion works let’s examine the detailed steps necessary to perform one.
Remember that this only applies to a handful of remarkably high earners. The average person does not have enough income to make this strategy work.
Most people can make tax-deductible contributions to their 401(k) and save a few tax dollars in the current year from that elective deferral.
However, if you are one of the few who could benefit from this procedure, here is how to accomplish it.
1) Ensure Your Plan Allows In-Service Conversions
First, ensure that your 401(k) plan allows for in-service distributions or conversions. If it does not, this entire strategy could be foiled.
That means you must wait until you leave your job to execute this strategy. Keeping that money in your traditional 401(k) for that long could lead to lots of additional taxes you were trying to avoid.
It might even mean paying capital gains taxes on the growth in your account when you finally get to perform the rollover. Ideally, you can perform an in-plan Roth conversion to simplify things.
If you cannot perform in-service conversions, you might want to discuss alternative options with your financial planner.
2) Max Out Your After-Tax 401(k) Contributions
Remember that the maximum amount you can contribute to your 401k in 2024 is $69,000 or $76,500 for those age 50 and older. The maximum pre-tax employee contribution is $23,000.
So, if your plan allows for after-tax contributions, then you can max those out depending on how much your employer contributes to your plan.
Let’s look at an example. Suppose you max out your pre-tax contributions of $23,000, and your employer matches that dollar for dollar. That brings the total to $46,000. So, you could still contribute an additional $23,000 in after-tax dollars before hitting the annual limit on total contributions of $69,000.
These after-tax dollars will eventually be rolled into a Roth account during this process. If you have no employer match and are entitled to catch-up contributions, the mega backdoor process could allow you to roll up to $53,500 into a Roth account.
3) Rollover Your After-Tax Portion To A Roth Account
Now, it is time to take that after-tax money and roll it over into a Roth IRA. This is when you will get to experience tax-free growth in your account.
You must perform this rollover as soon as possible. If the funds are allowed to grow in the 401(k), you will pay taxes on the growth when the rollover is performed.
However, once the funds are in the Roth account, the growth happens tax-free.
4) Pay Attention To Tax Implications
It is extremely important to know the details of these rules and enlist the help of a financial advisor or tax professional when needed.
If done improperly, the tax rate on the money you move could be very high. If you wait too long, you might owe capital gains taxes on some of the funds you rollover.
An unexpected tax bill could damage your personal finances, so make sure that you know exactly what the implications of performing this process will be.
Pro Rata Rule Consideration
The pro rata rule can also have significant tax implications. It states that if your 401(k) contains pre-tax and after-tax dollars, your withdrawals must be pro rata. They cannot come exclusively from either the pre-tax or after-tax dollars.
This rule has some workarounds, but you should consult your tax professional to determine what will work best in your situation.
TIP
A Solo 401(k) for small business owners is an excellent tool for establishing a Mega Backdoor Roth strategy. If you own a business without any employees and are high-income, you could contribute over $60,000 annually to a Roth account—close to 10 times more than a Roth IRA.
When You Should Use A Mega Backdoor Roth
The Mega Backdoor Roth strategy works excellently for high-income earners and small business owners who want to maximize their Roth contributions but have limited options.
If you are a small business owner without employees, you can establish a Solo 401(k) and add the Mega Backdoor option to your plan.
To maximize your Roth contributions, you can establish a Roth 401(k), a Pre-Tax 401(k) for company matches, and an after-tax 401(k). This will allow you as the employee to contribute $23,000 to a Roth 401(k) and then maximize the mega backdoor Roth (after-tax) contribution with an additional $46,000 contribution.
If your plan does not allow after-tax contributions, this strategy will likely not work for you. If you are below the income limits for a Roth IRA, you should make those contributions directly.
Hopefully, your employer’s plan doesn’t fail the IRS nondiscrimination tests required of all qualified retirement plans. Otherwise, they may be forced to return part of your savings to you, which might complicate your plans to roll that money into a Roth account.
Alternatives To A Mega Backdoor Roth
So, maybe you don’t have enough income to make this strategy work for you, but your income is too high to contribute to a Roth IRA. What can you do in that case? There are a few alternatives to a mega backdoor Roth, and we will discuss those here.
Taxable Investment Account
Consider opening a taxable brokerage account that allows you to invest in stocks or mutual funds. Some stocks pay great dividends, and the stock market has traditionally provided great returns over the long run. This can be a great alternative way to invest your money.
Regular Backdoor Roth IRA
A regular backdoor Roth IRA is not as complicated as the mega version but can provide some of the same benefits.
You can still get your money into a Roth account and enjoy tax-free withdrawals at retirement. There are not nearly as many hoops to jump through, and your income does not need to be as high to enjoy the perks of the regular backdoor Roth.
Simply contribute funds to a regular IRA and then perform a Roth conversion. Just make sure that you don’t have additional pre-tax dollars in other accounts like a SEP IRA, SIMPLE IRA, or others because you could create an unintended taxable situation.
Roth 401(k) Options
This is a great option for increasing your Roth contributions and allows you to enjoy tax-free withdrawals at retirement. If your employer offers access to a Roth 401(k), then that can be a great alternative to the mega backdoor strategy. Remember that Roth versions exist for both an IRA and a 401(k).
The Bottom Line
The mega backdoor Roth conversion can be a great way to save considerable sums of money into a Roth IRA, even if your income is above the Roth limits.
Several things must fall into place for this strategy to work, but it can be very effective when it does. Now you should have a great idea of what this strategy is and when you might be able to take advantage of it.
If you are highly compensated and need a way to save more money for retirement, this strategy might be right for you.
Frequently Asked Questions
No, not everyone can do a Mega Backdoor Roth.
- First, the 401(k) plan in which you participate must allow after-tax contributions and in-service rollovers or withdrawals.
- Next, you should be putting away enough money to max out your 401(k) contributions and a traditional IRA before considering a mega backdoor Roth.
Otherwise, you would not see a benefit to attempting this strategy.
The most significant benefit is that it allows you to contribute tens of thousands of dollars into a Roth account even if you are above the income limits for Roth IRA contributions.
This means that your money can grow tax-free until retirement and that you can make tax-free withdrawals from your contributions to the plan.
The most money that you can transfer with this strategy is $46,000. It is not likely that you will be able to hit this limit because this assumes that you have no employer match into your traditional 401(k). However, this might be possible for those with a solo 401(k).
A regular Roth IRA contributes funds directly to the Roth account. To be eligible to contribute, you must fall below certain income limits.
A mega backdoor Roth IRA is somewhat of a loophole in the tax laws that allows you to put funds into a Roth IRA even if you earn more than the income limits. It lets you place a large sum of money (up to $46,000) into the account.
Yes, you can execute both of these strategies in the same year. The regular backdoor Roth is done through an IRA account that you establish yourself.
The mega backdoor Roth is performed through your 401(k) that your employer sponsors.
You can find a Social Security Administration office near you by using our SSA office locator and searching for your closest location.
