Should I Consider a Mega Backdoor Roth IRA?

Reaching retirement requires hard work, discipline, and the implementation of some key planning strategies. While saving is a fundamental concept of helping you reach your retirement goals, saving in a tax diversified manner goes beyond the basics to potentially provide an even more effective game plan for retirement. You’ve likely heard of a backdoor Roth IRA, but for some looking to maximize their withdrawals in retirement, a mega backdoor Roth IRA may be the way to go.

What is a backdoor Roth IRA and mega backdoor Roth IRA? Below we’re breaking down what you need to know about these retirement savings strategies.

A Reminder About Traditional IRAs vs. Roth IRAs

The money you contribute to your Roth IRA is after-tax dollars, meaning you will have already paid income tax on it before putting it into your account. In turn, that money continues to grow tax-free. Because you already paid taxes on that income before contributing it to your Roth IRA account, you generally do not have to pay taxes on it when you withdraw money in retirement. This, essentially, creates tax-free withdrawals in retirement.

If you choose to place your money in a traditional IRA account, you are using pre-tax dollars. This means the money has not been taxed, which can be an effective strategy in lowering your present taxable income. In return, the money in your traditional IRA account grows tax-deferred. Once you reach retirement and begin making withdrawals, you will be responsible for paying taxes on the withdrawals.

So, if you were able to accumulate money in both tax-free bucket and a tax deferred bucket, you may be able to create a flexible withdrawal strategy for your retirement years that can minimize taxes over the long-term. Getting more money in a Roth bucket has the additional benefit that Roth IRAs do not have required minimum distributions.

With both traditional and Roth IRA Accounts, there are restrictions and annual maximum contribution limits that may be adjusted annually by the IRS. Before contributing to your account, you’ll want to check these limits or ask your financial advisor to clarify.

Backdoor Roth IRA Explained

Roth IRA accounts have income limits. In 2021, you are ineligible to contribute to a Roth IRA account if your adjusted gross income exceeds certain thresholds (and the phaseouts start even earlier):

$140,000 or more as a single filer

$208,000 or more as a joint filer

If you are a high earner with an income above the IRS’s income limit for Roth IRA accounts, you may still have the option to create a backdoor Roth IRA. Just as it sounds, this option may allow high earners to bypass the income limits and still utilize the tax advantages of a Roth IRA account.

Here’s how to create a backdoor Roth IRA account in a nutshell:

Open and contribute to a non-deductible traditional IRA. Make sure you record your basis, or the amount of the non-deductible contribution.
After a certain period of time, convert your traditional IRA to a Roth IRA account (your account administrator will provide the necessary paperwork and instructions to do this).
Once tax season rolls around for the year of conversion, pay taxes on any additional gains your traditional IRA account may have from the point of contribution and the point of conversion. The idea is that there will be little to no gains on the conversion if you make the conversion relatively near the time of the IRA contribution. Consider whether any estimated taxes are due in your situation.

Note that you do need to be aware of the IRA basis aggregation rule. If you have existing IRAs already set up before you attempt such a conversion, discuss with your tax planner or tax-focused financial planner about whether this should be done in your situation. In short, more analysis and planning strategies should be considered when you have outside IRA assets.

What Is A Mega Backdoor Roth IRA?

While a regular Backdoor Roth IRA may generate significant tax savings over the long-run, the amount of contributions to the regular IRA is a bit limited. Enter the mega backdoor Roth IRA. (There is no magic in the name of this strategy, but it was somehow coined in the industry and the name has stuck. You will not see it in the tax code or regulations. In fact, one could say it does not provide a proper description as it does not necessarily involve an IRA. I would suggest that a better name for this strategy is the Employer Plan Backdoor Roth Maximizer.)

A mega backdoor Roth IRA is a complicated strategy that allows high earners, or perhaps someone who has ample investable assets, to contribute up to $37,500 (2021) in a Roth IRA or Roth 401(k) account - on top of their regular contributions. This option is not available to everybody, as many 401(k) plan providers do not allow it. The amount that one could contribute is further limited by the concept of “Annual Additions” – the total annual amount than can be contributed to a 401(k) is the sum of the employee elective deferrals, the employer contributions, and the employee’s after-tax contributions. Catch-up contributions do not count against this limitation.

If you’re considering this option, you’ll want to work with your financial advisor or CPA to determine first whether it may be beneficial to you, and whether or not you may be hit with an unexpected tax bill as a result.

How Does a Mega Backdoor Roth IRA Work?

In order for a mega backdoor Roth IRA to work, your employer must allow two things: 1) after-tax voluntary contributions to be made to your 401(k) account, and 2) the ability to move your after-tax money to a Roth bucket (discussed below). You’ll want to check with your human resources department or plan administrator to determine whether these options are available to you. (I have found that it is more likely available with larger companies, but there is no reason why small companies cannot have it part of the plan. Depending on the recordkeeper or Third Party Administrator, there may be additional charges to get this incorporated into the employer’s plan.)

These contributions would be a separate bucket of money from your regular 401(k) contributions, and they would not count toward your 401(k) employee elective deferral limit.

Next, you need to move such after-tax money to a Roth bucket. Again, your employer’s plan needs to allow for such. They may allow you to remove money from your 401(k) plan (while you are still employed and working at the company) into either a Roth 401(k) portion of your plan (or, an in-plan Roth conversion) or out into a Roth IRA account (via an in-service withdrawal) outside of the 401(k) plan.

If your plan does not allow either option, you may be limited to waiting until you leave your job to have the opportunity to roll that after-tax money into a Roth IRA account. If this is the case, the benefits of this strategy may not be as effective and may likely should not be done – but, it depends on your overall financial situation and time period.

Again, you need to be mindful of the tax consequences and whether any estimated taxes or overall taxes need to be paid at the appropriate time.

Who Does a Mega Backdoor Roth IRA Work Best For?

Mega backdoor Roth IRAs are complicated strategies with lots of steps, and they aren’t ideal for everyone. In fact, it won’t be an option for most people. This strategy is typically most useful for those who max out their regular employee elective deferrals and earn too much to be eligible for a Roth IRA. In addition, these people have ample cash flow or outside cash that can be saved into the after-tax bucket of their 401(k). Depending on the individual’s tax rate and overall situation, this strategy has the potential to add to the tax diversified nature of retirement assets and provide significant savings over the long-term.

If you are a business owner that either has a Solo 401(k) or is considering implementing a Solo 401(k), this can especially be useful for you as well. The savings to the Roth bucket or after-tax contributions do not have the same negative effect that pre-tax 401(k) contributions have on your potential qualified business income deduction.

If this doesn’t sound like you, you may be better off utilizing a traditional or Roth IRA account and your 401(k) account to save for retirement. (Of course, don’t forget about the Health Savings Account, when applicable.)

It’s not a simple process, but if you think a mega backdoor Roth IRA may be the right option for you, have a conversation with a financial planner or tax professional to get started. If you happen to work with a boutique investment advisory firm that is tax-focused such as Oasis Wealth, you can likely get the coordinated approach that such a strategy requires.

¹https://www.irs.gov/retirement-plans/amount-of-roth-ira-contributions-that-you-can-make-for-2021