A mega backdoor Roth is a unique 401(k) rollover strategy designed for people whose incomes would normally prevent them from saving in an individual Roth retirement account. The advantage of using a Roth IRA to save for retirement is that you can make tax-free withdrawals. But not everyone can contribute to these accounts. higher incomes are excluded. That’s where the Roth mega backdoor comes into play. If you have a 401(k) that you’d like to roll over, you could use this strategy to enjoy the tax advantages of a Roth IRA without income being a barrier.
Make sure you take every opportunity to maximize your retirement assets by working with a financial advisor.
Roth Account Basics
Before diving into the specifics of a mega backdoor Roth, there are a few things you should know about Roth accounts, including Roth IRAs and Roth 401(k)s.
First, these accounts are both funded with after-tax dollars. This means that when you make eligible withdrawals later, you won’t pay income tax on the money since you’ve already paid it up front. This is the key feature of Roth accounts and what makes them so attractive to investors who expect to be in a higher tax bracket in retirement.
Then, your ability to contribute to a Roth 401(k) is not limited by your income. But it is for a Roth IRA. For tax year 2021, you must be within these modified adjusted gross income limits to make a full Roth IRA contribution:
Individual files: MAGI $125,000 or less
Married filing jointly: MAGI of $198,000 or less
Head of Household: MAGI $125,000 or less
You can make some contributions above these income limits. But your ability to phase in is phased out entirely once your MAGI reaches $140,000 (if you’re filing single or head of household) or $208,000 if you’re married and filing jointly. For 2021, the full allowable contribution is $6,000 with a $1,000 catch-up contribution for savers aged 50 and over.
Finally, Roth 401(k) accounts are subject to required minimum distribution rules, just like traditional 401(k) accounts. This rule requires you to start taking money from your 401(k) starting at age 72. A Roth IRA, on the other hand, is not subject to the RMD rules.
What is a Backdoor Roth?
A backdoor Roth offers a solution for people whose incomes are above the limits set by the IRS. When you perform a backdoor Roth, you transfer money from a traditional IRA to a Roth account. That way, you won’t have to pay taxes on your Roth IRA retirement savings when it’s time to make withdrawals. And they are not subject to the required minimum distribution rules either.
But there is a catch. You must pay income tax on the money you transfer to a Roth account. So while you could save money on taxes in retirement, you don’t completely escape the tax liability of a traditional IRA.
How a Mega Backdoor Roth Works
A mega backdoor Roth is a backdoor Roth designed specifically for people who have a 401(k) plan at work. This type of backdoor Roth allows you to contribute up to $38,500 to a Roth IRA or Roth 401(k) in 2021. This is in addition to the regular annual contribution limits the IRS allows for these types of accounts. To perform a mega backdoor Roth, two conditions must be met. Your 401(k) plan must allow for the following:
You can ask your plan administrator if your 401(k) meets these criteria. And if your plan doesn’t allow in-service withdrawals or distributions, you could still attempt a mega backdoor Roth if you plan to leave your job in the near future.
If your plan qualifies, then you can take the next steps to perform a mega backdoor Roth. This is usually a two-step process that involves maxing out your 401(k) after-tax contributions and then withdrawing the after-tax portion of your account into a Roth IRA.
Again, whether you can follow the second step depends on whether your plan allows in-service withdrawals. If not, you’ll have to wait until you separate from your employer to roll over any after-tax money in your 401(k) to a Roth IRA.
You also need to be aware of the pro rata rule. This IRS rule says you can’t just withdraw pre- or after-tax contributions from a traditional 401(k). So if you’re completing a big backdoor Roth, you couldn’t just withdraw after-tax contributions if your account contains both pre-tax and after-tax funds. In this case, you may need to roll over the entire balance to a Roth IRA.
Benefits of a Mega Backdoor Roth
There are three main advantages associated with performing a mega backdoor Roth. First, you can contribute significantly more to a Roth IRA upfront this way. For 2021, the contribution limit is $38,500 in addition to the regular annual contribution limit and any restrictive contribution limits that may apply.
You should know the maximum amount you are allowed to contribute to the after-tax portion of your 401(k). So for 2021, the IRS allows a maximum contribution of $58,000, or $64,500 if you’re 50 or older. You would subtract your 401(k) contributions and anything your employer adds in matching contributions to figure out how much you could add to the after-tax portion.
You can then enjoy tax-free withdrawals in retirement. This is a benefit you may not otherwise be able to receive if your income is too high to contribute to a Roth IRA. By reducing your tax liability in retirement, you can help your investment dollars go further. And you may have a greater legacy of wealth to pass on to future generations.
Finally, a mega backdoor Roth IRA would allow you to bypass the required minimum distribution rules. This means you could retain control over when you choose to take distributions from a Roth IRA.
So, who is eligible for a mega backdoor Roth? You may consider this move if:
Have a qualifying 401(k) plan at work
You’ve maxed out traditional 401(k) contributions.
You are not eligible to contribute to a Roth IRA because of your income
You have extra money you want to invest for retirement
Want to take advantage of the higher Roth IRA contribution limits allowed by a mega backdoor conversion
Talking to your financial advisor can help you decide if a mega backdoor Roth makes sense. And your 401(k) plan administrator should be able to tell you if it’s possible, based on your plan’s guidelines.
Mega Backdoor Roth Alternatives
If you can’t perform a mega backdoor Roth because your plan doesn’t allow it, there are other ways to increase your retirement savings. For example, you could try a regular Roth backdoor. This may be something to consider if you still want to enjoy the tax advantages of a Roth IRA, but your plan doesn’t qualify for a mega rollover. You could also choose to make Roth 401(k) contributions to your retirement plan at work. That way, you still have the benefit of contributing after-tax dollars and making tax-free withdrawals. You will be subject to normal contribution limits and must take the required minimum distribution. But that may outweigh the value of the tax savings in retirement.
Investing in a health savings account (HSA) is another option. Although these accounts are not specifically designed for retirement, they can provide multiple tax benefits. Contributions are tax deductible and grow tax-deferred. Withdrawals are tax-free when used for eligible health care expenses. And at 65, you can take money out of an HSA for any reason without a tax penalty. You’ll just owe ordinary income tax on any withdrawals not used for health care expenses.
Finally, you could open a taxable brokerage account to invest. This does not necessarily save you money on taxes, as you will owe capital gains tax when you sell investments at a profit. But it could help you diversify your investments, and there are no limits to how much you can invest in a brokerage account per year.
A mega backdoor Roth strategy could work well for higher income earners who want to take advantage of the benefits of a Roth account. However, there are some rules that must be followed for it to work, so you may want to speak to your plan administrator or a tax professional before proceeding. Also keep in mind that even if you can’t complete a mega backdoor Roth rollover, you have other options for growing retirement savings.
Tips for planning for retirement
If you’re saving for retirement in a 401(k) or IRA, pay attention to the fees you pay. For example, check the expense ratios for each fund you’re invested in to understand how much you’re paying to own that fund on an annual basis. You can then compare this to the fund’s performance to determine if the fees are justified. Also, consider any administrative fees you may be paying and how they affect your net returns.
Consider talking to your financial advisor about a large backdoor Roth and whether it might be right for you. If you don’t yet have a financial advisor, finding one doesn’t have to be complicated. SmartAsset’s Financial Advisor Matching Tool makes it easy to connect with professional advisors in your area. You can get your personalized recommendations in minutes by answering a few simple questions. If you are ready, start now.
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