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When it comes to saving money for retirement, you should already know that IRAs are an essential part of the retirement planning process. There are two different kinds - a Roth and a Traditional IRA, and the rules surrounding them are pretty straightforward.
However, depending on your particular situation, you may be able to take advantage of a mega backdoor Roth IRA. Not everyone can do this, but if you can, it could be highly beneficial for getting you to retirement as quickly as possible.
So, with that in mind, we want to dive into the world of IRAs, retirement savings, and how a mega backdoor Roth IRA works.
Realistically, it’s challenging to understand how to utilize a mega backdoor Roth IRA without first knowing everything about these accounts. However, let’s look at a quick description so that you know what to expect once we do get into the details.
A mega backdoor Roth IRA allows you to contribute an additional $37,500 (2020) to your retirement account by using certain rules relating to your employer-sponsored 401k plan. Considering that the annual cap for Roth IRAs is currently $6,000 ($7,000 if you’re over 50) in 2020, this is a big deal.
However, not everyone can take advantage of it, and there are strict rules and guidelines regarding how it can all come together. Still, knowing that you can put so much money away to grow tax-free is more than enough of an incentive to learn how it works.
Before we get into the nitty-gritty of making a mega backdoor Roth IRA work for you, let’s take a closer look at IRAs and retirement planning in general. This way, you can make sure that A) you know what to expect, and B) you can determine if this option is even available to you.
For some people, a good way to save money for retirement is with a traditional IRA. While we won’t get into too much detail, here are some of the essential elements that you need to understand about these accounts.
Whether you’re a struggling artist, a middle manager, or a doctor, everyone can contribute to a traditional IRA (however, whether the contribution is tax-deductible or not will be based on your income). Roth IRAs, on the other hand, can be out of reach when your income is over the allowable limits.
Once you reach 70.5 years old, you have to start taking money out of your IRA. The exact amount varies based on different factors, all of which are a little too complicated to get into here.
Even if you have plenty of cash on hand during your golden years, you’re required to pull funds from your traditional IRAs. Yes, you can then re-invest this money (rather than spending it), but it can’t sit in your account anymore and you will have to pay taxes on what you’re required to take out.
Your Adjusted Gross Income (AGI) is the total taxable income within a given year with a few deductions. If you put money into a traditional IRA, you can deduct those contributions from your AGI as long as you’re within the income limits for that year.
The advantage here is that it will lower your overall income. This also means that you could potentially put yourself in a lower tax bracket, which could save you even more money.
On the other side of things, you will have to pay taxes once you take the money out - either because you need it or because of those RMDs. However, the best part is that the funds are taxed at your current income level, not the level you were at when you contributed.
For example, if you’re retired and aren’t making any money (beyond RMDs), your tax bill will be considerably less than it was when you contributed to the IRA, all things being equal.
In 2020, individuals can put up to $6,000 per year into a traditional IRA. If you’re 50 or older, then you can add an extra $1,000. This contribution limit is the same for both traditional and Roth IRAs. At first, this may seem confusing because a mega backdoor Roth IRA allows up to $37,500 to be added, but we’ll get into that later.
Finally, if you’re younger than 59.5, you can’t take money out of a traditional IRA without incurring taxes and possible penalties. Not only will you have to pay taxes on it (at your current income level), but you’ll be hit with an additional 10 percent penalty if it doesn’t qualify as an exception.
Since 1997, individuals can add money to a Roth IRA in addition to a traditional account. However, while Roth IRAs are somewhat similar, they have some specific features that can make them seem much more appealing. Let’s make some comparisons to see how they differ.
Unfortunately, if you make too much money in a given year, you can’t contribute to a Roth. There are actually two income limits to worry about, though. For individuals making more than $124,000 in 2020, they can’t max out a Roth IRA. For couples, that total is $196,000. At these limits, you can still contribute, but you can’t reach the maximum threshold.
If you make more than $139,000 as an individual in 2020, you can’t put any money into a Roth directly (backdoor conversions are still open, however). For married couples, the limit is $206,000.
Thankfully, if you do a Roth conversion, then you can get around these income restrictions. This strategy is the backbone of a mega backdoor Roth IRA.
If you’ve been planning for retirement for a while, then chances are you will have multiple revenue streams in your golden years. So, rather than pulling funds from your IRAs, you may prefer to let that money sit and build over time.
Fortunately, you’re not required to take distributions at any age with a Roth. This rule also means that you can keep the funds in the account and pass it to an heir tax free.
The reason why Roth IRAs are so appealing to investors and retirees alike is that the money grows tax-free. When you contribute to a Roth, you don’t get to deduct those funds from your AGI. If you’re paying a lot in taxes right now, this strategy may not seem appealing, as the contribution is taken from your taxed income.
However, the tangible benefit here is that both the principal amount (the money you put in) and any earnings (interest) are tax-free when withdrawn. That being said, if you’re younger than 59.5 years old, you will have to pay both taxes and a 10% penalty for any earnings you withdraw from your Roth. There are a few situations where these penalties don’t apply, though, such as if you’re permanently disabled.
Contribution limits are the same for Roth IRAs as traditional accounts, but there are no penalties for withdrawing the principal balance from a Roth. This means you can pull out what you’ve contributed any time without getting hit with a penalty (unless it’s appreciated earnings, which trigger the age requirement).
Now that we know the difference between traditional and Roth IRAs, let’s dive into how a mega backdoor works. Considering the tax-free growth of a Roth, many people will want to convert as much cash as possible. However, this particular strategy is relatively complex, which means that you will likely need to consult with a financial advisor to do it correctly.
For you to take advantage of the mega backdoor Roth IRA, you need to know the difference between various IRA contributions. The three types are:
Currently for 2020, the maximum amount that a person can put into a 401k is $57,000, or $63,500 if you’re over 50. For individuals, the amount is technically $19,500 (the extra comes from employer matching and other tactics).
For a mega backdoor Roth IRA to work, you will have to put after-tax contributions into your 401k plan. Since you can’t go over the $57,000 threshold, you will need to do some math to find out how much you can add.
For example, if you contributed the maximum amount to your 401k in the year 2020 ($19,500), and your employer matched a total of $5,000, that would leave you with $32,500 left that you could put in as an after-tax contribution ($57,000 - $5,000 - $19,000).
If your employer doesn’t put any funds into the account, then your total contribution limit could be $37,500 (hence the figure we described at the beginning). While you don’t get as much of a tax incentive on this money, it’s still worth it to add more to your 401k since it should appreciate tax-free over time. If you are over 50, then you can take even further advantage of this practice and grow your nest egg even faster.
As we mentioned, this tactic is relatively complicated. Unfortunately, not everyone can take advantage of it since there have to be a few elements in place before you can move forward. Here is what you need to make a mega backdoor Roth IRA work.
Not all 401k plans allow you to put after-tax money into the account. According to a recent survey, less than half (43%) of all 401k plans enable employees to utilize this type of contribution.
Once you put the after-tax money into your 401k, you will need to transfer it to either a Roth IRA or Roth 401k. Once the funds move to a Roth IRA or Roth 401k, the money grows tax-free, even though it was an after-tax contribution (they will still do the same if you leave it in a traditional 401k as long as your provider keeps track of your after-tax contributions along with earnings).
However, if your employer plan doesn’t allow for that, you will need to wait until you leave your job to transfer that money. In that case, it may be better to try a different method of growing your retirement.
The reason is because the after-tax money will increase during the interim. If you transfer it immediately, you don’t have to worry about paying taxes on any earnings. If you have to wait 5 or 10 years, your tax burden will be higher.
Ideally, you will be able to maximize your mega backdoor Roth IRA conversion, which means that you can contribute to reach the $57,000 threshold for 2020. If you don’t have that kind of disposable income, however, then this tactic probably isn’t the best solution. Realistically, this method is designed for those individuals that can max out their contributions for their 401k and a Roth IRA account with money left over.
If you don’t fit that description, a mega backdoor Roth IRA probably isn’t feasible. However, depending on how much you can contribute, you may still want to pursue this plan. No matter what, we suggest talking with your financial advisor first.
When it comes to your financial future, you don’t want to make any mistakes. While a mega backdoor Roth IRA sounds appealing, you need to be sure that you can take advantage of it to the fullest extent. Feel free to contact us today to find out more about how you can qualify or what other options you may have available.
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NextGen Wealth, LLC is a registered Investment Advisor. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities product, service, or investment strategy. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial advisor, tax professional, or attorney before implementing any strategy or recommendation discussed herein.
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