The recent passage of the Tax Cuts and Jobs Act has reduced tax brackets and increased the attractiveness of the Roth IRA, whose qualified distributions are income-tax free in retirement, thereby offering individuals another way to diversify their tax exposure in retirement.
Obviously, if you are interested in funding a Roth account, the first place to look is to see if you can contribute directly to a Roth IRA. Next, you can check to see if your employer offers a Roth 401(k), which does not have the income restrictions as the Roth IRA does. Both of these options are the easiest and most straightforward way to contribute to Roth accounts.
Luckily, with advanced planning strategies, such as the backdoor and mega backdoor, individuals with proper planning can bypass these income limits. And, in a previous post, I discussed the backdoor Roth strategy as a way of getting around the income restrictions in order to contribute to a Roth IRA. Now, I will take it a step further: Meet the mega backdoor Roth.
The first thing to know is that this option is not available to everyone. In fact, to get started, you must have an employer-sponsored retirement plan, such as a 401(k), that allows you to contribute after-tax dollars beyond the standard annual limit.
Next, this is typically for high-income earners who have the ability to save a massive amount of income. You want to be comfortable with your cash flow and ability to save before considering this strategy.
If you have an emergency fund set up, low or no outstanding debts, maxing out your retirement contributions, and still have the ability to save even more, this strategy may be a smart move.
This strategy is one of the only ways to save beyond the “standard” annual savings limits (for 2021, that’s $19,500 plus $6,500 for those age 50+) up to the maximum 401(k) limit of $58,000 (and $64,500 for those age 50 and older).
In general, individuals in a position to consider the mega backdoor strategy are typically in a high tax bracket, based purely on the fact that they are not only able to max out the standard annual savings limits but also have the additional saving capability. And those in a high tax bracket will usually benefit from first taking advantage of saving strategies that can lower taxable income.
Of course, one of the first places to look is maxing out contributions to a traditional 401(k). Next, it may also be a smart idea to consider funding an HSA, which will further reduce taxable income while increasing tax-deferred and tax-free savings. Finally, if you have children and are interested in saving for their college education, it may make sense to think about contributing to a 529 account. Saving for retirement should be a priority for everyone, but it is always a good idea to look at all of your savings goals as well.
If you have determined that a mega backdoor Roth is for you and your current 401(k) plan allows after-tax contributions, clarify with your HR department whether or not you can take in-service distributions (which allow you to take money out of your 401(k) account while still employed). If the answer is yes, then you can make yearly rollovers of this after-tax money into a Roth IRA. If your plan does not allow for in-service distributions, then the after-tax money that you are saving will remain in the plan until you separate from service, at which time you can roll that money directly into a Roth IRA.
As much as $38,500 can be contributed to a Roth IRA using the mega backdoor strategy in 2021. In order to determine how much you can actually contribute towards the mega backdoor strategy, you must consider employee and employer contributions. Here’s how the numbers break down:
For 2021, the maximum amount that can be contributed to a 401(k) is $57,000. If you are age 50 or older, the limit is $64,500. These limits include both employee and employer contributions. But the standard annual contribution limit for an employee is $19,500 and $26,000 for those age 50 and older. The first step in this process is to max out those limits.
Next, you want to add your contribution amount to any employer contributions. Then, you want to subtract that amount from the above maximum amounts of either $58,000 or $64,500. The difference is what you can additionally contribute on an after-tax basis to the plan.
Let’s look at an example:
You make pre-tax 401(k) contributions of $19,500. Your company has contributed $5,000. This means $24,500 has been contributed towards a maximum total contribution of $58,000. You have the ability to save additional money this year. You can contribute an additional $33,500 of after-tax contributions into your 401k. This $33,500 can be converted to a Roth account using the mega backdoor strategy.
One caveat, any gains on the after-tax contributions are to be rolled to a traditional IRA. If you convert any gains to a Roth, you’ll have a tax liability on those gains. Consider the graphic below on the mechanics of the mega backdoor conversion.
Mega Backdoor Steps
For those entrepreneurs who are self-employed, you may not think the mega backdoor strategy is possible since you don’t have a work-sponsored 401(k). But This is where a solo 401(k) can become a valuable tool. A solo 401(k) is a retirement plan designed for the self-employed.
Since you are responsible for establishing the solo 401(k) plan for yourself, you can ensure the plan allows for after-tax contributions as well as in-service distributions. As with all 401(k) plans, the maximum limit for employer and employee contributions is $58,000. And $64,500 for those age 50 and older.
As an employee, you are allowed to contribute up to $19,500 or 100% of compensation (the lesser amount) for 2021 (+$6,500 age 50+).
As the employer (which is also you), profit-sharing contributions may be made up to 25% of compensation if you file as an S Corp. For those that file as a sole proprietorship or single-member LLC, contributions are limited to 20% of net business profit.
Consider this example of how the solo 401(k) can be an asset for a self-employed person who wants to utilize the mega backdoor Roth strategy.
You are a solopreneur and make $19,500 in pre-tax contributions and 25,000 in profit-sharing contributions as the employer. This means a total contribution of 44,500. Since the maximum limit is $58,000, this allows for an additional $13,500 that can be contributed on an after-tax basis! This amount can then be converted using the mega backdoor strategy!
The mega backdoor Roth is a tool that can allow you to put savings into overdrive. This is a potential strategy if you are looking for ways to optimize your long-term savings strategy and create additional tax diversification. Advanced planning strategies, such as the mega backdoor Roth have many moving pieces and tax implications if done incorrectly. It’s important to consult your tax professional and CERTIFIED FINANCIAL PLANNER™ professional before implementing any of these strategies.