Mega Backdoor Roths: What Is It & How They Work | Full Guide

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Most people want to maximize the amount of money they stash away for retirement, but the IRS places limits on 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? By utilizing a mega backdoor Roth, you might be able to stash away as much as $45,000 extra into your Roth IRA or 401k. So, what is a mega backdoor Roth and how do they 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 you can fully understand how a mega backdoor Roth works, you need to know the basics of Roth accounts in general. 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 make withdrawals. 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, those withdrawals are taken tax-free. Everybody loves tax-free money, but not everyone is able to participate in every Roth option. Let’s take a look at a Roth IRA vs a Roth 401(k).


Roth 401k

If your employer offers a Roth 401k option, then anyone can participate regardless of income. The same contribution limits apply to a Roth 401k that apply to a traditional 401k. You can only place $19,500 into your Roth account in 2021. Your employer is also allowed to 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 $6,000 per year. This amount increases to $7,000 for those age 50 and older. However, not everyone is eligible to participate in a Roth IRA. It is possible that you might have too much income to be eligible for a Roth IRA as high-income earners are unable to 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 $140,000, then the IRS does not allow you to contribute to a Roth IRA. Similarly, married couples with an adjusted gross income of over $208,000 cannot contribute.


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. When it comes to 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.

First, you need to have the money in a non-Roth IRA. This can be done by direct deposit into the account or by performing a rollover from your 401(k). Remember that the IRA contribution limits still apply here. So, the maximum contribution that you can make to this IRA is $6,000. 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, then you will need to 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 will be able to get this money into a Roth account even if you are a high earner. When you roll the money into the Roth account, then you will have to pay income taxes on those dollars. Try to move the money as quickly as possible because if it grows inside the traditional IRA, then you will owe capital gains taxes on that growth! Once the rollover has been performed and the income taxes paid, then your Roth IRA is done and you can later take tax-free withdrawals. This can lead to big tax savings during retirement! Most brokerages can assist with this process and setting up your accounts like the Vanguard backdoor Roth.


How Does A Mega Backdoor Roth Work

The mega backdoor Roth IRA allows you to save a large sum of money in a Roth IRA, but this strategy will only work for a few people. In fact, it can allow you to put away up to $45,000 into a Roth IRA even if you exceed the income limits that normally apply. Here is how it works.

First, you need to make sure that you have maxed out your employee contributions to your traditional 401(k). Otherwise, this strategy doesn’t make much sense as you will see no real tax benefits from it. You will want to max out your employer contributions to your 401(k) as well. In 2021, that means that you should have contributed the full maximum of $19,500 into your account, and your employer can contribute up to $38,500 into your account. If you are age 50 or older, you also can make catch up contributions of $6,500. On top of this, some plans allow you to contribute additional after-tax dollars. The $19,500 limit is simply the most tax-deferred money that you can put into the plan per the IRS.

If you contribute after-tax dollars to your account once you have maxed out your pre-tax contributions, then those dollars are still taxed upon withdrawal. However, as you know, Roth account withdrawals are tax-free. Next, your 401k plan must allow in-service withdrawals. Once you place the after-tax dollars into the 401k, then you should perform an in-service withdrawal and roll the funds into a Roth IRA. That’s it! Now you have maxed out your regular 401(k) contributions, and you have funded your Roth account with a large sum of money as well.


4 Steps To Perform A Mega Backdoor Roth IRA Conversion

Now that you understand how a mega backdoor Roth conversion works, let’s take a look at the detailed steps necessary to perform one. Remember that this only applies to a handful of extremely high earners. The average person does not have enough income to make this strategy work. Most people will simply be able to make some 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, then here is how to accomplish it.


Ensure Your Plan Allows In-Service Conversions

First, you need to make sure that your 401k plan allows for in-service distributions or conversions. If it does not, then that could foil this entire strategy. That means that you would have to wait until you leave your job in order to execute this strategy. Keeping that money in your traditional 401k for that long could lead to lots of additional tax that 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 make things even simpler. If you are unable to perform in-service conversions, then you might want to discuss alternative options with your financial planner.


Max Out Your After-Tax 401(k) Contributions

Remember that the maximum amount that can be contributed to your 401k in 2021 is $58,000 or $64,500 for those age 50 and older. The maximum pre-tax employee contribution is $19,500. 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 that you max out your pre-tax contributions of $19,500 and your employer matches that dollar for dollar. That brings the total to $39,000. So, you could still contribute an additional $19,000 in after-tax dollars before hitting the annual limit on total contributions of $58,000. These after-tax dollars are what will eventually be rolled into the Roth account during this process, so if you have no employer match and are entitled to catchup contributions, the mega backdoor process could allow you to roll up to $45,000 into a Roth account.


Rollover Your After-Tax Portion To A Roth IRA

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. It is imperative that you perform this rollover as soon as possible. If the funds are allowed to grow in the 401k, then you will pay taxes on the growth when the rollover is performed. However, once the funds are in the Roth account, then the growth happens tax-free.


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 that you move could be very high. You might owe capital gains taxes on some of the money that you rollover if you wait too long. Your personal finances could take a hit from an unexpected tax bill, so make sure that you know exactly what the implications will be from performing this process.

The pro rata rule can also have some major tax implications. The pro rata rule essentially states that if your 401k contains both pre-tax and after-tax dollars, then your withdrawals must be made on a pro rata basis. They cannot come exclusively from either the pre-tax or after-tax dollars. There are some workarounds to this rule, but you should consult your tax professional to determine what will work best in your situation.


When You Should Use A Mega Backdoor Roth

You should really only consider utilizing a mega backdoor Roth when your income is high enough to max out your contributions to both your traditional 401k and a traditional IRA. In addition, you will want to max out after-tax contributions to your 401k as well. If your plan does not allow after-tax contributions, then this strategy will likely not work for you. If you are below the income limits for a Roth IRA, then you should just make those contributions directly.

If you have already maxed out your pre-tax contributions as well as traditional IRA contributions and still have money left over for additional savings, then this strategy might benefit you. Hopefully your employer’s plan doesn’t fail the IRS nondiscrimination tests that are required of all qualified retirement plans. Otherwise, they may be forced to return part of your savings to you which might put a wrinkle in your plans to roll that money into a Roth account.


Alternatives To A Mega Backdoor Roth

So, maybe you don’t have quite 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 Account Investments

Consider investing in traditional taxable accounts like stocks or mutual funds. Some stocks can 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 is not as complicated as the mega version, and it can still provide many 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 an SEP IRA, SIMPLE IRA, HSA or others because you could create an unintended taxable situation.


Roth 401(k) Options

While this option might not allow you to stash away gobs of money, you can still enjoy the benefit of 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 401k.


The Bottom Line

The mega backdoor Roth conversion can be a great way to save large 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, then this strategy might just be for you.


Frequently Asked Questions

Can anyone do a mega backdoor Roth?

No, not everyone can do a mega backdoor Roth. First, the 401k 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 contributions to both your 401k and a traditional IRA before you consider a mega backdoor Roth. Otherwise, you would not see a benefit to attempting this strategy.


What are the benefits of a mega backdoor Roth?

The biggest benefit is that it allows you to put away up to $45,000 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 you can make tax-free withdrawals on your contributions into the plan.


What is the mega backdoor Roth contribution limit?

The most money that you can move with this strategy is $45,000. 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 401k. However, this might be possible for those with a solo 401(k).


What is the difference between a mega backdoor Roth IRA and a regular Roth IRA?

A regular Roth IRA is where funds are contributed directly to the Roth account. You must fall below certain income limits to make these contributions. 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. In fact, it allows you to place a large sum of money (up to $45,000) into the account.


Can I do both a backdoor Roth and a Mega Backdoor Roth?

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 401k that is sponsored by your employer.