What is a Mega Backdoor Roth?

As you probably already know, a Roth IRA is an effective vehicle many investors use to save for retirement. What you may not know, however, is that individuals in higher tax brackets are unable to contribute directly to a Roth IRA due to IRS-imposed income limitations. One corresponding solution is to enlist the help of what’s called a “mega backdoor” Roth strategy.

Though this option isn’t available to everyone and is often complex, investors looking to contribute more money to these accounts might find it’s worth considering.

In this post, we’ll cover everything you need to know about mega backdoor Roth IRAs including what they are, how they work, advantages and disadvantages, and how to evaluate if they’re right for you.

What is a mega backdoor Roth?

To gain a full picture of mega backdoor Roth strategy, it’s essential to first have a basic understanding of IRAs, Roth IRAs, and backdoor Roth IRAs. Let’s dive in.

Roth and traditional IRAs
An IRA (individual retirement account) features various tax benefits and is designed specifically to help fund your retirement. You can invest in many assets within the account including stocks, bonds, ETFs, and mutual funds. While many different types of IRAs are available, traditional and Roth IRAs are the two most common options.

With a traditional IRA, you put pre-tax dollars into the account; this money grows over time, and you pay tax obligations when making a withdrawal.

A Roth IRA is similar, except you add after-tax money; this money grows over time, and you can then withdraw sums equivalent to contributions you’ve made—both penalty and tax-free—at any time and for any reason. If you’re at least age 59½ and want to withdraw from the earnings portion of the account, you can do so tax-free provided you’ve owned the account for at least five years (known as the “five-year rule”). This rule does have some exceptions, and you can read all about Roth IRAs here.

Roth IRA income & contribution limits
If you’re a single filer with a modified adjusted gross income (MAGI) exceeding $153,000 (in 2023), you are not eligible to contribute to a Roth IRA. If your MAGI is more than $138,000 but less than $153,000, you can contribute—but only a reduced amount. These limits will rise to $161,000 and $146,000 in 2024.

The maximum MAGI limit is $228,000 for those filing jointly, based on contribution qualifications. If your joint MAGI exceeds $218,000 but is less than $228,000, your maximum allowed annual contribution is reduced. These limits will rise to $240,000 and $230,000, respectively, in 2024.

Furthermore, if you are under age 50, the maximum annual contribution limit for both traditional and Roth IRAs is $6,500 for 2023 ($7,000 in 2024); those aged 50 or older can contribute an additional $1,000 (note limits do change annually). This extra $1,000 is known as a “catch-up” contribution and expected to be adjusted annually for inflation in 2024 based on SECURE 2.0 Act legislation.

Backdoor Roth IRAs
Backdoor Roth IRAs are often sought after by individuals who are not eligible for a Roth IRA (due to a higher income) and investors looking to reduce their tax burden during retirement.

There are several ways to utilize a backdoor Roth IRA, each of which often requires converting a portion or all traditional IRA funds to a Roth IRA; taking such action requires one to pay taxes on the converted money.

Mega backdoor Roth strategy overview

A mega backdoor Roth strategy allows individuals to contribute up to an additional $43,500 (for a total of $66,000, or $73,500 for individuals 50 and older) of 2023 after-tax dollars into a Roth IRA and/or Roth 401(k). The following are required to implement this strategy:

·      A 401(k), 403(b), or 457(b) plan with your current employer (in the examples that follow, we’ll refer to 401(k)s to keep things simple)

·      A Roth option with your current employer either in the form of an IRA or 401(k)

·      Allowable after-tax contributions that exist separately from traditional 401(k) and Roth 401(k) contributions. This criterion is vital, as it increases the maximum you and your employer can contribute to your 401(k) from $22,500 to $66,000 ($73,500 for individuals 50 and older) in 2023. It’s estimated that fewer than half of all 401(k) plans allow after-tax contributions, so check with your benefits plan administrator accordingly.

·      Allowable in-service distributions or conversions. Your employer must allow you to withdraw money from the plan as a current employee (in-service distribution) or alternatively move money from the after-tax portion of your plan into the Roth 401(k) plan portion.

How a mega backdoor Roth works

A mega backdoor Roth strategy entails three steps:

First, you’ll need to make the maximum pre-tax contribution to your 401(k) for the year. In 2023, this amount is $22,500 ($30,000 if you are 50 or older).

Once you’ve maxed out your 401(k) contributions, you then make additional after-tax contributions up to the 401(k) limit for the year—$66,000 or $73,500 for those aged 50 and older. Note that these are aggregate limits and include:

·      Your contributions in step one.

·      Your after-tax contributions. 

·      Any matching contributions your employer has made. 

Once the first two steps are complete, the third step is rolling money over from the after-tax contributions bucket into a Roth IRA or converting it into a Roth 401(k).

Once the money is in the Roth account, you’ll enjoy tax-free growth and no tax bill when you withdraw the money (provided you adhere to Roth IRA withdrawal rules). 

Mega backdoor Roth advantages

A mega backdoor Roth is a popular option, and for good reason: those meeting eligibility criteria receive a whole host of benefits that are otherwise unavailable. Some key advantages include:

The ability to save more for retirement
Simply put, mega backdoor Roth IRAs allow you to contribute significantly more to your retirement plan and add thousands of additional dollars to the fund. If you make the most of this availability each year, you’ll occupy an extremely strong position after departing the workforce.

Paying less in taxes later on
If you’re a high earner, you may not know what to do with any spare income after maxing out your annual 401(k) contributions. A mega backdoor Roth strategy allows you to pay taxes now and not worry about any implications associated with Roth withdrawals during retirement.

Helping to secure your financial future
A mega backdoor Roth allows you to make hay while the sun shines. While you may have high earning power right now, you have no idea what might happen in the future: meaning that a mega backdoor Roth strategy can give you the peace of mind that you’ll enjoy substantial financial security regardless of any unexpected circumstances.

Mega backdoor Roth disadvantages

Mega backdoor Roth strategies might sound absolutely perfect, but we assure you they’re not; after all, there’s no such thing as the perfect retirement plan. Key disadvantages include:

A high level of complexity
While it’s easy to open a Roth IRA, implementing a mega backdoor Roth strategy is not as easy as the process is often confusing. Speak to a financial expert if you’re considering going this route.

Limited availability
Mega backdoor Roth strategies are not very common because most employers (with the exception of many large companies and solo 401(k) plan participants) do not offer after-tax contributions or in-service distributions within their retirement plan.

The five-year rule
The earnings portion of your Roth IRA must generally sit in your account for at least five years, and you’re unable to make tax-free withdrawals prior to age 59½.

The need to save extra money
You must make a considerable salary and/or save additional funds to fully leverage a mega backdoor Roth strategy.

Limiting employer contributions
While employer matches and profit sharing are great, remember that the amount they contribute can stifle your ability to make after-tax contributions as this counts towards your maximum contribution limits. Also be mindful of your employer making profit-sharing contributions at the very end of the calendar year; if you’ve already maxed out your after-tax contributions and the profit-sharing contribution puts you above allowable limits for the year, your employer must send money back as a corrective distribution. Such situations can trigger a taxable event due to earnings on overcontributed money.

Who should consider a mega backdoor Roth strategy?

Though they offer many advantages, mega backdoor Roth strategies aren’t for everyone. They might be right for you, however, if:

• You don’t qualify for a traditional Roth IRA because you earn more than $139,000 annually

• You can make after-tax contributions to your employer’s 401(k) plan

• You’ve maxed out your pre-tax 401(k) contributions

• You have enough cushion with respect to your day-to-day expenses and thus feel comfortable socking more money away for retirement

The bottom line: mega backdoor Roth IRAs

Utilized correctly, mega backdoor Roth strategies provide a viable way for high earners to reap some benefits of traditional Roth IRAs that are otherwise unavailable. They offer tax benefits and the chance to solidify retirement plans for eligible employees, but given their high level of complexity, we recommend speaking to a financial advisor to learn if they’re right for you.

Still have questions about a mega backdoor Roth? Schedule a FREE Discovery call with one of our financial advisors.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.