Supercharge your Roth IRA
Many people have heard of a "Backdoor Roth IRA". It is a process by which high income earners who are no longer eligible to make direct Roth IRA contributions are instead able to perform annual Roth conversions to accomplish a similar result. If specific criteria are met, these conversions are exempt from federal income tax. This is a strategy we frequently employ with clients who can benefit from it.
A "Mega Backdoor Roth IRA" builds upon this strategy in the world of Defined Contributions Plans (specifically 401(k) and 403(b) plans), but requires that certain conditions be met which are typically out of your control as a plan participant.
To execute a "Mega Backdoor Roth IRA", your 401(k) or 403(b) plan must allow for After-Tax Contributions and either In-Service Distributions or In-Plan Rollovers to Roth.
First, the Plan must allow for After-Tax Contributions. Not Roth, specifically After-Tax. If this feature is not available, you won't be able to execute a "Mega Backdoor Roth IRA".
Second, the Plan must allow for either In-Service Distributions or In-Plan Rollovers to Roth. An In-Service Distribution of your After-Tax Contributions will allow you to transfer these dollars from the Plan to any Roth IRA in your name. An In-Plan Rollover to Roth will allow you to push the after-tax monies into your Roth 401(k)/403(b) account – this keeps the money within the Plan, but allocates it to the Roth portion. If neither of these features are available, you probably won't want to execute a "Mega Backdoor Roth IRA" (more on this below).
If your employer's Defined Contribution Plan checks both of these boxes, congratulations! You are eligible for a "Mega Backdoor Roth IRA"! There are several big companies we know of – including Amazon, BP, Google, Facebook, PayPal, Zillow, Boeing, Pfizer, Uber, Zoom, and more – that have set up their plans to allow for this strategy. If you own your own business, you can work with your TPA to amend your plan to add these features.
Now that we've established how to determine if you're eligible for a "Mega Backdoor Roth IRA", let's talk about who would want to execute this strategy and how much money you can contribute.
WHO MIGHT WANT TO EXECUTE A "MEGA BACKDOOR ROTH IRA"?
► You contributed the maximum to your 401(k)/403(b) – $19,500 for those under age 50 and $26,000 for age 50+ in 2021.
► You contributed the maximum to your IRA or Roth IRA via a conversion – $6,000 for those under age 50 and $7,000 for age 50+ in 2021.
► You contributed the maximum to your Health Savings Account (HSA) if applicable – $3,600 for individuals and $7,200 for families in 2021.
► You have additional after-tax savings that you want to put towards retirement.
This strategy is best suited for high income earners with extra cash on hand who want to contribute as much as possible to their retirement accounts. If you are not already "maxing out" your 401(k)/403(b), IRAs, and HSA for you and your spouse, that's where you may want to start before considering a "Mega Backdoor Roth IRA".
HOW MUCH CAN YOU CONTRIBUTE?
The contribution limit for Defined Contribution Plans is $58,000 for those under age 50 and $64,500 for those over age 50 in 2021. This limit combines contributions from both the employee (you) and the employer, likely via a matching or Safe Harbor program. To calculate how much you can contribute to the Plan on an After-Tax basis, you must subtract your total payroll contributions and total employer contributions from your applicable limit.
Let's look at an example. Christy is 53 and earns $250,000 per year. She has contributed the maximum $26,000 into her 401(k). Her employer matches 100% of contributions up to 3% of compensation. The total employer match is $7,500 ($250,000 x 3% = $7,500). Christy can contribute $31,000 After-Tax to the plan ($64,500 limit - $26,000 401(k) contributions - $7,500 employer match = $31,000). That $31,000 can then be rolled into Christy's Roth IRA or Roth 401(k) to grow tax-free, thus completing her "Mega Backdoor Roth IRA".
WHAT HAPPENS IF YOU DON'T ROLL THE AFTER-TAX MONEY OUT?
If you contribute to your plan on an After-Tax basis, but do not roll funds out either to a Roth IRA or Roth 401(k)/403(b) to complete the "Mega Backdoor Roth IRA" process, any investment earnings on those dollars would become taxable to you upon withdrawal from the plan at Ordinary Income rates. Some plans allow you to push these earnings into your Traditional 401(k)/403(b) account upon withdrawal to defer this taxation.
As such, by adding to the Plan on an After-Tax basis but not completing the "Mega Backdoor Roth IRA" you would be negating the tax benefits of this strategy and likely causing yourself additional taxation. If you had simply left these after-tax funds in an investment account, you would instead pay Capital Gains tax on any earnings, which has historically been much lower than Ordinary Income tax rates.
The "Mega Backdoor Roth IRA" can be a great way to supercharge your Roth IRA contributions. However, there can be unintended tax consequences from executing such a strategy, and it's not ideal for everyone. Make sure you discuss potential plans with your resident Dashboard Planning ninjas or your tax advisor before executing.
Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period.