Roth IRAs have an attractive tax incentive, which is that they make tax-free withdrawals during retirement possible. However, income limits exist for those who qualify to use this tax-advantaged account. In 2024, the income limit for single tax filers is $161,000, and $240,000 for those who file married on their taxes.
There is a potential strategy for those who exceed the Roth income limits. The mega backdoor Roth strategy can be used to stash money in a Roth regardless of your income.
What is a Mega Backdoor Roth?
Mega backdoor Roths allow high-income earners to indirectly contribute to a Roth through a workplace retirement plan like a 401(k) or 403(b). The two main things needed to do a mega backdoor Roth include after-tax contributions to a 401(k) account and then a conversion of those after-tax funds into a Roth. It’s imperative to note that not everyone has access to these types of accounts. This will limit who can do a mega backdoor Roth. Not every employer offers the option of after-tax 401(k) contributions or allows conversions.
The Benefits of Doing a Mega Backdoor Roth
The reason why people use the mega backdoor Roth strategy is so that they can take advantage of the tax benefits that come with Roth IRAs. Traditional IRAs and 401(k)s, while allowing for tax-deductible contributions and tax-deferred growth, are taxed on the distributions. While this may be okay for clients who have lower incomes in retirement and, as a result, have a lower tax rate, this may not be ideal for those with higher incomes in retirement. Converting those excess funds into a Roth account gives these clients the benefit of tax-free income in retirement.
There are other benefits that come with Roth IRAs. Because the funds put into a Roth are already taxed, there is no mandatory withdrawal of the funds in retirement, which exists with traditional and 401(k) accounts. This gives you greater control over when to distribute the funds. Roth IRAs can also be an asset in estate planning since the beneficiaries can inherit them tax-free.
How to do a Mega Backdoor Roth
After Tax 401k Contributions
The first step in doing a mega backdoor Roth is contributing after-tax dollars to a 401(k). After-tax dollars are funds you’ve already paid taxes on, so this does not include dollars that go to the traditional pre-tax or Roth sides of a 401(k).
To break this down further, in 2024, the IRS allows a maximum contribution by both you and your employer into a 401k is $69,000, or $76,500 if you are over the age of 50. The most you can contribute as an employee in pre-tax dollars into a 401(k) is $23,000 or $30,000 if over age 50. This leaves up to $46,000 more, which can be contributed to the account in after-tax dollars. This number will decrease if your employer contributes to the account.
As an example, let’s say you are age 45 and have maxed out your 401(k) traditional or Roth contributions for 2024, contributing $23,000. In addition, your employer matches 25% of those contributions, putting an additional $5,750 in your account. That means the contribution total comes up to $28,750 so far. You could contribute an additional $40,250 in after-tax dollars before you reach the overall limit of $69,000.
Roth Conversion Using After-Tax Dollars
Once after-tax dollars have been added to a 401(k), the next step in the mega backdoor Roth strategy is to use those dollars to do a Roth conversion. This is where those after-tax 401(k) dollars are converted to a Roth.
The two options in which this can be done are an in-plan conversion or an in-service withdrawal. With an in-plan conversion, after-tax 401(k) dollars are converted into a Roth 401(k) at the same employer. For those who choose to do the in-plan conversion, ensure your employer offers this feature. If your after-tax contributions have earnings or gains, you’ll have to pay taxes on that amount.
A second option is to roll after-tax dollars into an external Roth account, which is also known as an in-service withdrawal. Any earnings amassed on the 401(k) contributions can also be rolled into the Roth, but that would likely result in a tax bill. The objective is to let the tax-deferred contributions and earnings remain in the 401k. Alternatively, one could roll the earnings into a traditional IRA to defer taxes and avoid paying them now. Keep in mind that on both in-plan conversions and in-service withdrawals, future contributions aren’t taxed since you made them with after-tax dollars.
Also, there are no limits on how much money you can convert into a Roth IRA, and there are no limits to in-plan conversions.
Is a Mega Backdoor Roth Right for You?
Mega backdoor Roths can be a smart and legal way to put money into a Roth when you have income limit restrictions. Additionally, it can be an effective strategy for people who want to contribute more than the annual contribution limit to an IRA. That contribution limit is $7,000 in 2024 and $8,000 for those 50 and older.
That said, before doing Roth conversions, it’s important to consider the tax implications. If you need help planning a mega backdoor Roth or understanding how it fits into your financial goals, speak to someone on our team today.
