By Ryne Vickery, CFP
If you’re a mega-saver with a mega-income, the mega backdoor Roth IRA option might be something you should investigate. And soon, because new legislation proposes eliminating it in 2022. So, then, what is it? At a basic level, the mega backdoor Roth IRA allows a specific subset of savers to put up to $38,500 into a Roth IRA by using their employer-sponsored 401(k) plan to make after-tax contributions. Clear as mud? Let’s dive in….
First, for those with income above the threshold to directly contribute to a Roth IRA, let’s revisit what a “regular” backdoor Roth IRA is. Assuming you have no money in any other pre-tax IRAs, allowing you to avoid the pro-rata rule (more on that later) and a hefty tax bill, in 2021 you can make a $6,000 non-deductible traditional IRA contribution ($7,000 if you’re over 50), and then convert that to a Roth IRA. This is a great strategy to get more money into a tax-free Roth and diversify your tax buckets.
The mega backdoor Roth IRA may be an option to even further increase contributions to the tax-free Roth. To fund a mega backdoor Roth, you must confirm that your 401(k) plan allows for two things: 1) after-tax contributions (not Roth 401(k) contributions) beyond the $19,500 pre-tax contribution limit; and 2) in-service distributions out of the 401(k) plan. Unfortunately, many 401(k) plans do not have both features, so it is important to confirm.
After checking that your 401(k) plan permits it, the process to complete the mega backdoor Roth isn’t too different from the steps for a regular backdoor Roth IRA.
Max Out Your After-Tax 401(k) Contributions
Assuming you have already maxed out your standard 401(k) contributions (for 2021, $19,500 or $25,000 if you’re over 50), you’ll also want to calculate how much your employer is contributing to the plan. To keep things simple, let’s assume there is NO employer contribution in the following example.
For 2021, the IRS limits total 401(k) contributions to $58,000. Let’s say you’ve maxed out your standard contributions of $19,500, which then gives you the possibility of making an additional $38,500 in after-tax contributions into your 401(k).
Take an In-Service Withdrawal of the After-Tax Contributions
Let’s next assume that you’ve gone ahead and made that $38,500 in after-tax contributions. After doing so, you can then take an in-service withdrawal of that amount from your 401(k) and move it into your Roth IRA.
You will want to make the in-service withdrawal as quickly as possible, because any growth of your after-tax contributions will be counted in your pre-tax bucket, NOT the Roth bucket. Be sure to keep comprehensive records of all transactions.
Once the money is moved into your Roth IRA, you can invest it and it will grow tax-free, forever!
What to Watch Out For
The IRS says that you are NOT able to roll ONLY after-tax amounts out of your retirement plan. You must take out a pro-rata portion of both pre-tax and after-tax amounts for the transaction to be in good standing. For example, let’s say you have a $100,000 401(k) balance consisting of $60,000 in pre-tax money and $40,000 in after-tax money, and you wish to move $30,000 of after-tax money into a Roth. The pro-rata rule says you must take out an equal proportion of pre-tax money as well. Thus, you would also need to withdraw $45,000 of the pre-tax money into a traditional IRA (meaning you’d withdraw 75% of both the pre-tax and after-tax dollars).
However, a subsequent option is to simply reverse roll the pre-tax dollars out of the traditional IRA and back into the 401(k). Again, be sure to keep a record of all transactions.
Additionally, be sure that you’re not utilizing this strategy in lieu of another that may benefit you more. Evaluate your IRAs, HSAs, 529s, and debt/mortgage situation to see if your money could be better used elsewhere first.
As you can see, the mega backdoor Roth can be a great way to juice your retirement savings, assuming you have maxed out all other applicable savings vehicles. Make sure to talk to your financial or tax advisor to determine the best path forward for you.
About the author: Ryne Vickery, CFP®
As a Wealth Advisor with Buckingham Strategic Wealth, Ryne Vickery, CFP®, works with his advisory team to develop comprehensive financial life plans for professionals, retirees and near-retirees, and same-sex couples who want to align their money with their goals and values.
Important Disclosure: The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Strategic Wealth®. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice. Individuals should speak with qualified professionals based upon their individual circumstances. The analysis contained in this article may be based upon third-party information and may become outdated or otherwise superseded without notice. Third-party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. IRN-21-2661