This method can help you save exponentially more money on a tax-free basis. Introducing the mega backdoor Roth IRA.
Mastering the Mega Backdoor Roth IRA: What Is It and How to Execute
If you knew a tool that could potentially maximize your retirement tax savings, would you be interested in it? If your answer is yes, then read on to learn more about the mega backdoor Roth IRA concept. I’ve saved over $25,000 in retirement fees but that’s not enough.
The mega backdoor Roth IRA best fits anyone who is already maxing out all their retirement accounts and can help one to make an extra income of up to $36,000 per year which goes to your Roth IRA contributions.
It is a tax-advantaged approach to save some more on top of your retirement savings and gives your long-term savings a boost.
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So what is the mega backdoor Roth IRA?
The mega backdoor Roth IRA Conversion is a way to contribute indirectly to Roth IRA if you do not qualify to contribute directly due to high-income. To be able to contribute to a Roth IRA account directly, you have to meet certain income limits. This can help boost your personal financial ratios and net worth upon retirement.
But if you make more than the income limits, and have made gains, you can still contribute to a non-deductible traditional IRA. The mega backdoor Roth leverages on this fact to allow one to convert the non-deductible traditional IRA contribution into a Roth IRA account.
A Roth IRA account is a retirement savings account that allows your contributions to grow free of taxes. Roth is funded with after-tax money, meaning taxes have already been deducted on the cash you contribute into it.
Roth contributions grow, and the growth is, and you pay no taxes either upon withdrawal.
Here’s the catch.
The Internal revenue service (IRS) guidelines state that you can divert your pre-tax 401k portion and all the growth on the investment to your traditional IRA and the after-tax contributions to your Roth IRA without making any tax payments.
The mega backdoor IRA comes in handy if you are allowed to make in-service distributions and so can be able to transfer your 401k to IRAs. The strategy can help you to save and boost your Roth IRA contributions.
Let’s look at five simple steps to help you understand how the backdoor Roth IRA works.
Make sure that you don’t have any other pre-tax IRA accounts
The first step is to max out all other tax-advantaged accounts including your regular 401(k) contributions, regular IRA contributions, a health savings account, and a regular Backdoor Roth IRA among others.
Also make sure that you eliminate any other traditional IRAs, SIMPLE IRAs or SEP IRAs that could cause potential problems unless the ultimate goal is to convert them into Roth IRAs.
The best way to eliminate them is by rolling them over into an employer-sponsored plan such as 403, 401k or 457, a method commonly called reverse IRA to 401k rollover.
It’s important to note that you can only rollover pre-tax money, and therefore any previous non-deductible contributions don’t qualify for this.
See Related: How I Saved Thousands in Retirement Fees
Make sure that your 401(k) allows for the mega backdoor Roth IRA
The next step is to start making contributions to your mega backdoor IRA. Here, you open a Traditional IRA Account and a Roth IRA Account at the same time. Then, contribute $5,500, which is the 2019 limit, as a non-deductible contribution to your Traditional IRA.
Remember you need to find out whether you’re eligible to do the mega backdoor Roth IRA since it depends on the types of contributions your 401(k) permits and how it lets you to access those contributions.
Here are the three key things that you need to consider:
- The ability to make non-Roth after-tax contributions
To take advantage of this strategy, you only have to be able to make non-Roth after-tax contributions and not all 401(k) plans allow them.
- The ability to make in-service withdrawals
Various programs will enable you to withdraw your after-tax contributions even while you’re still with the company. It is helpful, though not mandatory because it allows you to take maximum advantage of this mega back door Roth strategy since you can send your contributions into a Roth IRA immediately.
- After-tax contributions are held in a separate sub-account
Another feature to consider is that after-tax contributions and their earnings are kept in a separate sub-account from your other 401(k) contributions. If you don’t have this feature, you can’t take advantage of the in-service withdrawals because you wouldn’t be able to roll over just the after-tax portion of your 401(k).
If your 401(k) allows for non-Roth after-tax contributions, you can then proceed to Step 3. If it doesn’t, unfortunately, you can’t use the mega backdoor Roth IRA strategy.
If your 401(k) also allows in-service withdrawals plus keeps after-tax contributions in a separate sub-account, you can then go to Step 4.
If it doesn’t meet either of the above two criteria, you can opt for Step 5.
Make non-Roth or after-tax contributions
The next step is actually to make your non-Roth after-tax contributions. The specific logistics of doing that vary based on the different types of 401(k).
The maximum contribution one can make $54,000, minus your other employee and employer contributions. Theoretically, it means that you could contribute up to $36,000 per annum which is after subtracting the $18,000 employee contribution.
Often, for a significant number of people, the maximum contribution will be lower since the employer will likely contribute money to your 401(k) as well. So, whatever amount the employer contribution will also have to be deducted.
See Related: Best Investing Apps to Use Today
Immediately roll over to a Roth IRA
Ideally, if your 401(k) plan will allow both accounts for your non-Roth after-tax contributions in a separate sub-account and allow for in-service withdrawals, you can roll your after-tax contributions to a Roth IRA instantly after contributing them to your 401(k).
Your contributions will be tax-free during the rollover, but your earnings will be taxed. Since you’re doing it immediately, your gains will be minimal, and therefore the taxes will also be minimal. And once the rollover is complete, all of your contributions plus the returns on them will grow tax-free and will be tax-free even upon retirement.
It’s important to let your 401(k) plan administrator understand your intentions to avoid any unintended consequences. And the specific mechanics of doing so differ by 401(k) provider and by the IRA provider that you choose as well
Rollover to a Roth IRA after you exit your current company
This is an alternative option to consider if your 401(k) doesn’t allow for in-service withdrawals or if your non-Roth after-tax contributions aren’t kept in a separate sub-account since you won’t be able to do an immediate rollover.
Here, you’ll likely have to wait until you end your work contract with your current employer before you can roll over the after-tax contributions into a Roth IRA.
So, those after-tax contributions may build up significant earnings that will potentially be taxable when you do the rollover.
It’s likely to be still worth taking advantage of this strategy even at this point because when you do roll the money over, you’re permitted to split the rollover so that all your pre-tax money goes to a Traditional IRA and all your after-tax money goes to a Roth IRA.
It allows you to avoid what could have been a substantial immediate tax cut, it keeps your pre-tax money growing tax-deferred in a Traditional IRA, and so you can still get significant money into a Roth IRA that will eventually be tax-free.
You can then screen for individual stocks to put in your Roth IRA or participate in index investing.
Conclusion on the Mega Backdoor Roth IRA
Stay motivated with your financial plan with these inspiring financial planning quotes. Mega backdoor Roth IRA is an ideal indirect strategy to contribute plenty of thousands of dollars to a Roth IRA every single year, regardless of your earnings.
What is vital to know is that the success of the strategy depends heavily on your 401(k) and IRA providers, and so you’ll need to work closely with them to make sure they understand your plan.
This can be an unbelievable way to max out significant money that will be completely tax-free upon retirement. Check out our other wealth management resources to find what best suits you to better your financial situation.
Are you going to try a mega backdoor Roth IRA? Please let us know in the comments below. We’d love to hear from you.
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Thanks Mark, glad you liked it!
Now I need to check with my 403(b) provider to see if they allow in-service transfers. I will definitely be coming back to re-read this post if they do. Thanks for all the great info.
Thanks Shawn! Hope all is well!
Does this Mega backdoor roth contribution include the (IRA backdoor to Roth IRA)? Or It’s different? In other words, Besides $56k, I still can do IRA contribution and backdoor conversion (another $6000).
Yeah that’s correct! Thanks for stopping by Kai!