Mega Backdoor Roth
Planning for retirement is a bit like the classic board game Chutes and Ladders in that there are two ways to play.
You can take the long way and slowly reach your destination, or you can take shortcuts and get there faster.
A mega backdoor Roth individual retirement account (IRA) is part of the shortcut route.
It’s designed for high-income earners who don’t qualify for a traditional Roth IRA.
Rest assured that despite the shady sounding name, a mega backdoor Roth is a perfectly legal and legitimate investment option.
In this post, you will learn everything there is to know about mega backdoor Roths.
What is a Mega Backdoor Roth?
Let’s back up a bit before we dive into this financial instrument and go over some basics.
What is an IRA?
An IRA is an individual retirement plan that provides income tax advantages for retirement savings.
There are many types of IRAs, including traditional IRAs, SEP IRAs, spousal IRAs, and SIMPLE IRAs.
Each IRA has its own set of unique rules and benefits.
The traditional IRA is the most common and basic non-Roth IRA.
Very simply, you contribute pre-tax dollars to your account. Over time, this money should theoretically grow, and you then pay taxes when you withdraw funds during retirement.
What is a Roth IRA?
One of the other most common types of IRAs is the Roth IRA, which allows an investor to set aside post-tax money for retirement.
All earnings that the account accumulates are tax-free, if you wait until after age 59 ½ to access your funds.
In some cases, you can also still access your Roth contributions prior to that age without paying taxes or penalties.
A popular benefit to a Roth account is that there aren’t any required minimum distributions (RMDs) that traditional IRAs have.
On the other hand, one of the biggest stipulations is that there are tax limitations that determine the maximum amount you can deposit each year.
In 2020, the Roth IRA contribution limit is $6,000, and if you contribute more than this, you will have to pay a 6% annual excise tax for the excess amount.
What is a Backdoor Roth IRA?
Backdoor Roth IRAs are available for people who are not eligible for a Roth IRA due to income limits. (Meaning they earn more than $139,000).
In a nutshell, the strategy allows you to roll over money from a traditional IRA account into a Roth IRA account.
While there are no limits restricting income or contributions, you will have to pay a large tax bill for pre-tax funds.
What is a Mega Backdoor Roth IRA?
Beyond the backdoor Roth IRA, is the mega backdoor Roth IRA, which allows you to contribute up to $37,500 to your Roth IRA or Roth 401k on top of additional retirement savings.
It’s a complicated process, but the results are well worth it if you can make it work.
In the next section, we’ll explore how it’s possible to leverage a backdoor Roth IRA.
How Does the Mega Backdoor Roth Work?
Unfortunately, not everyone is eligible for a mega backdoor Roth IRA. A few things must be in place, first.
For starters, your employer must offer 401k plans. Then, your 401k plan administrator must allow you to make after-tax contributions, which come into play beyond the standard employee deferral limits.
For 2020, the maximum contribution limit for 401k accounts is $57,000 — $19,500 of which can be pre-tax contributions.
Employer contributions go on top of that amount, so if your employer matches 4% of your contributions, that’s still considered pre-tax income.
Anything beyond this will be considered taxable income.
In addition to allowing after-tax contributions, the 401k must also allow the following:
1. In-Service Distributions
In-service distributions occur when an employee takes a distribution from a retirement plan while they are still employed with their company.
2. Non-Hardship Withdrawals
A non-hardship withdrawal is a 401k withdrawal that does not require a qualifying “trigger” event to access the funds without penalty.
It’s best to have a non-hardship withdrawal policy that comes with no restrictions in order to avoid complications.
How to Set Up a Mega Backdoor Roth
Here’s what you’ll need to do to get started.
First, figure out the maximum after-tax contribution that you can make for your 401k account. Then, after maximizing your after-tax contribution, the next step is to withdraw this amount and classify it as a Roth IRA conversion, or as a “Roth 401” account.
After you rollover the funds, the principal will not be taxable. So you get some nice tax savings there. However, all earnings on this Roth conversion will be taxable.
By this point, you can tell that setting up a mega backdoor Roth isn’t easy. So, it might be worthwhile to consult with a financial advisor— especially when you factor in the IRS’s pro-rata rule, which stipulates how much of your distributions and conversions are taxable.
That said, with the right plan in place, you can time your conversion to minimize your tax liability.
Mega Backdoor Roth Benefits
Now that you understand more about the nuts and bolts of the account, let’s take a look at some of the top advantages of using a mega backdoor Roth.
1. You Can Contribute More Towards Retirement
If you’re eligible, the mega backdoor Roth can let you contribute thousands of dollars extra towards your retirement.
Doing this repeatedly can put you in a great position down the line.
Remember: You don’t have to wait for your golden years to enjoy retirement.
Many people are putting more money aside when they are young, and using an investing strategy like the mega backdoor Roth can get you there faster.
2. Maximize The Money That’s Leftover
Oftentimes, investors will max out their retirement accounts and wonder what to do with their excess savings.
A mega backdoor Roth will prioritize your retirement — making it a worthy long-term investment.
3. Secure Your Retirement
Another benefit of using a mega backdoor Roth is that it can protect you down the line.
If you’re reading Millennial Money, chances are you’re young and in the prime of your career.
However, there’s no telling what can happen 10 or 20 years down the line. Any number of scenarios could arise that could potentially delay retirement, making you wish that you put in more when you were younger.
You never know what the future holds, after all. Using a mega backdoor Roth is a good way to build a secure future for yourself if you can afford it.
When to Avoid a Mega Backdoor Roth
It’s important to remember that the mega backdoor Roth isn’t for every type of investor. Just because you might be able to participate doesn’t necessarily mean you should.
For example, if you’re already maxing out your employee contributions, and your employer is making matching contributions, and you already have a backdoor Roth IRA, the mega backdoor Roth might be unnecessary.
Another reason to avoid a mega backdoor Roth IRA is because you have pressing short-term financial goals.
For example, you may be looking to buy a new house, put your kids through college, or pay down debt. Make sure you prioritize these immediate financial needs before making the decision to tie up your money until retirement.
Pros and Cons
- You can contribute six times more toward your Roth IRA than you otherwise would be able to
- You avoid wasting money that could otherwise be invested
- It makes it easier for you to potentially retire earlier
- Not all 401k programs allow for the mega backdoor Roth
- The process is confusing
- You have to make a considerable salary or make sacrifices and live frugally to leverage this plan.
Here are some of the more common questions I’m hearing about mega backdoor Roths.
Are Mega Backdoor Roths Common?
Nope. The mega backdoor Roth is not a common investment vehicle. This is largely because most employers do not offer in-service distributions and after-tax contributions.
Why would an employer give their team better benefits? (Har, har, har.) So, while many people would undoubtedly like to exercise this option, few are able to. That’s just the way it is.
In addition, a mega backdoor Roth is very expensive and out of the reach for the average nine-to-five worker. Making the most out of this kind of retirement account involves being very disciplined and committed to a secure retirement.
If you’re in a position where you meet the above-mentioned criteria, and you have the excess capital to contribute, you are strongly encouraged to look into this option.
It’s a great way to maximize your savings in the long run — and you will be among a small group of investors who are able to do so.
Can Solo 401k Owners Use a Mega Backdoor Roth?
Yes. Mega backdoor Roths are a viable choice for those who have a solo 401k plan, such as self-employed people or employees working for a company without a 401k plan.
A solo 401k plan will allow you to contribute about 25% of your pre-tax portion income to your 401k.
The trick is to set up your plan so that you can allow for in-service withdrawals and after-tax contributions.
Is it Risky to Use a Mega Backdoor Roth?
The only real risk to using a mega backdoor Roth is that you will essentially be putting large chunks of capital away into your retirement account, where you won’t be able to touch it for a long period of time without penalty.
Granted, this is the nature of planning for retirement and a risk that all serious retirement investors must make.
You can’t expect to retire if you are constantly tapping into your savings.
However, it’s a good idea to make a realistic assessment about your short-term goals before you take this route.
Is A Mega Backdoor Roth For You?
The mega backdoor Roth is a great investment option for high-income earners who have the cushion to set aside larger amounts of money for retirement.
However, not everyone is able to leverage a mega backdoor Roth due to account and income restrictions. And for some investors, it’s just not the right option.
The mega backdoor Roth can expedite retirement savings and set you up for long-term success. But every investor is different, and every investor’s portfolio is unique.
You know your risk tolerance and financial situation better than anyone else. So do your due diligence, and you’ll figure out the best way forward.
Since you’re reading these words, you’re already focused on retirement planning, and you’re ahead of the game. Keep at it, build a plan, and stick to it. I’m rooting for ya!