Mega Backdoor Roth IRA: How It Works Step by Step
Most people invest for retirement in an IRA or 401(k) rather than a savings account.
These accounts have tax advantages that make them worth using.
They also have annual contribution limits higher than most people decide to contribute. However, there’s a group of super savers trying to maximize their retirement plans each year.
They may earn an extremely high income and want to take advantage of the tax benefits. Others may want to retire early.
To do this, they put away as much of their income as possible in tax-advantaged accounts.
If you’re looking for a place to save even more money for retirement, you may want to consider a mega backdoor Roth IRA.
This isn’t a typical retirement account you can open at a brokerage firm, though.
Instead, it’s a complex method to maximize retirement contributions.
Here’s what you need to know.
What’s a Regular Backdoor Roth IRA?
Some people exceed the income limits to contribute to a Roth IRA the traditional way.
Instead, people may opt for a regular backdoor Roth account.
First, you contribute money to a traditional IRA account.
Then, you immediately roll it over to a Roth IRA before any earnings accrue.
You do have to pay taxes on the conversion, but these may just be on the contributions since there are no earnings.
Essentially, this allows you to contribute to a Roth IRA even if you don’t qualify due to the income limits.
Some complex tax situations make this situation a bit less clear, though.
This includes the pro-rata rule which may require some complex tax calculations.
Consult an advisor if you’re considering this to learn the complete details about how this works.
What Is a Mega Backdoor Roth IRA?
A mega backdoor Roth IRA is a strategy you use with a 401(k) at your workplace to maximize your retirement contributions.
Many people know that you can contribute up to $19,500 to 401(k) plans in 2021.
If you’re over 50, you can contribute an additional $6,500 for a total of $26,000.
People also realize their employers can contribute matching contributions or profit-sharing contributions.
Most people don’t understand that the total maximum contributions to a traditional 401(k) plan are much higher than you’d expect.
In fact, the total maximum contribution of both employees and the employer match in 2021 is $58,000 for those under 50.
For people 50 or older, the maximum total employee and employer contributions are $64,500.
This is a massive difference from the regular elective deferral contributions employees can make.
A mega backdoor Roth IRA takes advantage of the difference between these two limits to help you maximize contributions.
How a Mega Backdoor Roth IRA Works
A mega backdoor Roth IRA is a highly complex tax strategy.
If you don’t know what you’re doing, you could easily make mistakes.
They can also have unintended consequences.
For this reason, you should always consult an expert.
Then, you can discuss your particular situation before attempting this strategy. More on that later.
For a mega backdoor Roth IRA to work, you need to have a few things working in your favor.
First, you have to have enough money to save where you are already maxing out your 401(k) plan at work and your Roth IRA.
If you haven’t done these two things, focus on meeting these goals before considering a mega backdoor Roth IRA.
Figuring Out If You Can Use This Method
Once you’ve reached the point where you have excess money to invest, your 401(k) plan through your employer must meet specific requirements.
First, your 401(k) plan must allow after-tax contributions. If it doesn’t, you can’t use this strategy.
Next, your 401(k) plan has to allow one of the methods to enable the mega backdoor Roth IRA.
You either have to be able to make in-service distributions or have the ability to move money from an after-tax contributions section of your plan to the Roth 401(k) section of the plan.
Once you’ve determined you meet these requirements, executing this strategy should technically be possible.
How to Execute the Plan
Once you max out your 401(k) at your workplace, you need to make after-tax contributions to your 401(k) plan.
You have to be careful not to exceed the total contribution limit, though.
This limit includes any employer contributions or profit-sharing contributions.
Make sure to include these in your calculations.
Once you have money in your after-tax account, speed is of the essence.
You want to move your after-tax contributions to one of two places as fast as possible.
If the money has no earnings, there are no tax consequences.
If those investments increase in value, you can’t move the earnings to the Roth IRA without paying taxes on the earnings.
You can, however, move the earnings to a traditional IRA or leave the earnings in the after-tax part of your plan, instead.
The first uses an in-service withdrawal to remove the money from the 401(k) plan and add it to your Roth IRA.
The other option is moving the money to the Roth 401(k) part of your account using an in-plan rollover.
If Your Plan Doesn’t Allow In-Service Withdrawals
If your plan doesn’t offer in-service withdrawals, you can still use this strategy in a less ideal way.
You can contribute after-tax money to your account while you’re working.
Once you leave your employer, you’re free to roll over your 401(k) plan to the IRA of your choosing.
To avoid unintended tax consequences, you will have to carefully roll over after-tax funds based on whether they represent contributions or earnings.
Benefits of Using This Strategy
Using a mega backdoor Roth conversion to move money from an after-tax 401(k) account to a Roth IRA may be beneficial in many ways.
- Contribute even more money to retirement in a tax-advantaged way.
- Withdrawals from the account are tax-free in retirement if you follow the rules.
- Roth accounts don’t have to take required minimum distributions in retirement.
Drawbacks of the Mega Backdoor Roth IRA Strategy
Mega backdoor Roth IRA conversions aren’t always a good idea, though.
- These are complex to pull off correctly and can result in unintended tax consequences if errors are made.
- Your 401(k) plan may not allow them.
- You may save too much money for retirement and sacrifice enjoying life today.
Consult a Professional Before You Start
If you’re fortunate enough to have extra income to contribute to a mega backdoor Roth IRA, you should take precautions.
Chances are you’re a high-earning individual looking to get all of the tax advantages you can.
As you can tell, taking advantage of a mega backdoor Roth IRA is complex.
First, consult with your employer’s 401(k) plan.
Ask them to make sure you can make after-tax contributions as well as in-service withdrawals or rollovers.
If they say you can, the next step is consulting an investment professional.
These professionals can take a look at your entire financial picture.
Based on that information, they can help you determine if a mega backdoor Roth IRA is a good idea.
They may even be able to manage the account for you.
Before you find a professional to work with, you must ensure you understand how your advisor gets compensated and what type of advice they must give.
A fiduciary financial advisor must give you advice in your best interests.
Other advisors only have to give suitable advice that may result in some unscrupulous advisors lining their pockets with commissions.
Even fiduciary advisors can make money by recommending you move money under their management.
In particular, advisors that get paid under the assets under management model would be incentivized to get you to use a mega backdoor Roth IRA.
If you want to avoid this conflict, you can pay a fee-only fiduciary financial advisor that you pay for their time.
They may charge a flat annual fee or an hourly rate. Either way, this should remove the significant conflicts of interest typically present when working with an advisor.
Then, you can get genuinely objective advice about whether a mega backdoor Roth IRA is a good fit for you.
If it is, they can advise you on how to do it without having any unintended tax consequences.