Mega Backdoor Roth IRA – It Could Supercharge Your Retirement Savings

Last Updated: 3/5/2024

Income limits can preclude individuals and families from taking advantage of tax laws intended to help and encourage people to save for retirement and reduce their tax burden.

A Mega Backdoor Roth IRA strategy can help circumvent such limits and help put hundreds of thousands of dollars into your retirement account over time.

Introduction

Being a high-income earner would seem to be the ideal situation for most people. Sitting around drinking champaign and eating caviar, working the cushy job and breezing through life without a worry in the world.

Yeah, that’s tough…not likely to garner much sympathy from the average Joe.

Let’s get real. We all know the grass is always greener and everything is relative. Maintaining whatever life we’ve built for ourselves, with the accompanying lifestyle, as well as dreams and goals for retirement, is no easy matter.

And it’s certainly not cheap.

No matter what you have or how much you are saving, it’s only natural to try to maximize what you are able to save and accumulate. Equally important to reduce what you have to pay Uncle Sam in taxes.

Those things require a comprehensive retirement plan customized just for your family and situation. And it requires taking full advantage of strategies and opportunities that might be available to save and to reduce or minimize taxes, especially those you might owe in retirement.

One such opportunity for high-income earning individuals and families that can address maximizing savings while reducing taxes is the backdoor Roth IRA strategy.

And if eligible, the mega backdoor Roth IRA strategy, which can significantly increase the value of your retirement savings, even when your ability to contribute to retirement accounts can be limited because of how much you earn.

Today we are going to look at both strategies, with an emphasis on the latter, as it has the ability to potentially supercharge your savings over time.

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Mega Backdoor Roth Contribution strategy?
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Backdoor Roth

So, what is a backdoor Roth? Simply stated it is a strategy that enables you to contribute to a Roth IRA even when you normally wouldn’t be eligible to do so because of earned income restrictions.

There are in fact two main strategies you might be eligible to take advantage of if you find yourself in the unfortunate situation of making too much money…being a high-income earner. ☹ Just kidding…

The first is a backdoor Roth IRA contribution strategy, which offers some benefits, but frankly is not something we would necessarily recommend except in limited circumstances, which will be covered shortly.

The second, a mega backdoor Roth IRA strategy, is an approach that can offer you the ability to make a fairly sizable contribution on an annual basis, despite your income annually. We will cover that shortly.

Income limits

You’ve managed to scratch out a decent living in your job. And you’ve dealt with the issue of having limited ability when it comes to taking advantage of qualified tax-deferred or tax-free saving options because the government says you earn too much.

The IRS bases that determination of eligibility on a key factor – your modified adjusted gross income (MAGI). They use MAGI to determine qualification for premium tax deductions, credits and retirement plan eligibility.

According to Healthcare.gov, MAGI is comprised mainly of your adjusted gross income (AGI), which is a line item on your tax filing form (e.g., 1040). But it also includes untaxed foreign income, non-taxable Social Security benefits and tax-exempt interest. Note – MAGI isn’t listed as a line item on your tax filing form.

For most people, AGI and MAGI are identical or closely associated. We suggest you work with your CPA to ensure you are using the correct MAGI figure in terms of determining your eligibility for retirement plan contributions.

The 2024 income limit for contribution to a Roth IRA if your filing status is single is $146k to $161k. The area between the lower and higher figure is referred to as the phase out range, in which your eligibility to contribute is limited and then phased out and eliminated completely, according to the IRS.

If you’re married and filing jointly the 2024 limit for contribution to a Roth IRA is $230,000 to $240,000. The same holds true for couples in terms of the phase out of eligibility in this range.

An important point here is the fact that if your MAGI is lower than these limits, you are eligible to make the maximum IRA or Roth IRA contributions allowable by the IRS, so the backdoor Roth strategy is mute – you simply make your contribution in the normal manner (through the front door), with no need to go through the backdoor.

If instead you do make more than those upper limits, a backdoor Roth may be for you.

Backdoor Roth IRA contribution

So, how does the backdoor Roth work? Good question!

Assuming you earn too much for eligibility, you take money from your bank (or from under your mattress, buried in the backyard or anywhere you happen to be “saving” it) and deposit it into a traditional IRA account.

This action is known as a non-deductible contribution (there is no deduction when you file your taxes) utilizing after-tax dollars.

Despite the fact the dollars are after-tax and non-deductible, you are still limited in what you can contribute. The 2024 limit to a Roth IRA is $7,000, with a “catch up” provision of $1,000, according to the IRS. Assuming you are over 50, you can contribute $8k for the year.

You next move the non-deductible contribution that was made into the traditional IRA into the Roth IRA, which is considered a conversion. Despite the fact these are after-tax dollars, there is a potential tax consequence regarding this conversion, discussed in a moment.

When you do convert you gain the benefit of a Roth IRA contribution, in that those dollars won’t be taxed when you eventually take distribution later during retirement. And since this is a Roth IRA, the assets in the account aren’t governed by IRS regulations requiring required minimum distributions or RMD.

But…and it is an important but…any gain (interest earned on the converted amount) that you incurred during the period when the money was placed in the regular IRA and then later converted into the Roth IRA account would be treated as ordinary income and taxed.

For example, if you placed $8k into the IRA as a non-deductible contribution for the year, and before converting it into a Roth IRA it earned $1,000, you would have to pay taxes on the $1k as ordinary income, as those dollars had never been taxed.

We don’t usually suggest this

There are several reasons we don’t normally suggest the backdoor Roth IRA:

• Slow process – you can only contribute $7k to $8k annually
• Have to file IRS form 8606 annually (for the non-deductible IRA contribution, and for the Roth conversion), which is time consuming and a bit complicated
• IRS Pro Rata Rule, which requires that all IRA accounts (excluding Roth IRAs) be aggregated (IRA Aggregation Rule) and treated as one account for purposes of calculating conversion taxes and RMDs

Back to the potential tax consequence on the backdoor move of the money from the traditional IRA to the Roth IRA.

Due to the aforementioned IRS Pro Rata Rule, were you to make the maximum contribution of $8k for 2024 using this strategy, given it is first placed in the regular IRA, those funds would be considered lumped or commingled with the existing (collective) dollars you already have in your IRAs.

Because of this, the new contribution would be subject to partial tax. That’s even though the $8k placed in the Roth IRA was non-deductible, utilizing after-tax dollars.

To demonstrate, if you already had $200k combined in one or more IRAs, the $8,000 contribution gets lumped with that $200,000 for a total of $208,000. The $8k is then divided by the $208k ($8k/$208k) to determine what part of the new contribution is tax-free and which part you must pay tax on.

In this case, 3.8-percent would be tax free while the remaining 96.2-percent of the $8k would be subject to income tax.

Ouch!

According to our head honcho – Troy Sharpe, CFP®, CPWA®, CTS®, Founder and CEO – he wouldn’t suggest the backdoor Roth strategy if you already have other dollars in an IRA. That’s in addition to the other reasons listed above.

That said, he does point out that even though the backdoor Roth IRA strategy is limited in terms of annual contribution, and suitability (no if you already have IRAs), those dollars can grow over time to a sizable number due to the 8th wonder of the world – the principle of compound interest.

Mega backdoor Roth time

A different approach if you do have an employer-sponsored 401(K) plan might be the mega backdoor Roth IRA strategy. It could potentially put hundreds of thousands of tax-free dollars into your retirement accounts for use later in retirement.

Because this approach involves your 401(K) plan (with higher annual contribution limits), and there are no “income-based” limits for contribution to that type of account, the amount you can contribute is much higher than that of an IRA contribution. “You can contribute more money more rapidly” points out Sharpe.

This gets a little wonky, but follow along and it will become clear as to why the mega backdoor Roth IRA strategy may make sense for you.

First, you need to know that a typical 401(K) plan today might be comprised of three accounts – pre-tax, post (after-tax) and Roth 401(K), which is a Roth IRA managed within the plan. Despite the fact there might be three accounts in the plan, they are technically treated as just one account.

Second, the IRS limit for contribution to a 401(K) in 2024 is $69,000 for this purpose. (Note, there is a catch-up provision of up to $76,500 if you’re 50 or older, but only $69k is eligible for the purpose of the mega backdoor Roth IRA strategy). That covers both the pre-tax and the post (after-tax) accounts within a 401(K).

Theoretically you could contribute that entire amount ($69k) into the 401(K) account, but you would miss out on your available tax deduction and the employer match. Safe to say you are going to want to take advantage of both benefits.

As such, your contribution would actually be limited to the 2024 IRS 401(K) deductible limitation of $23k, plus the $7,500 catch up provision for being 50 or over. In total, your allowable qualified deduction for 2024 would be $30.5k.

And there is also the matching amount contributed by your employer, further bolstering your contribution for the year.

For sake of example, say you make $300k, and the employer matches dollar-for-dollar up to 4-percent of your salary, in this case they would contribute $12,000.

• Your contribution – $30,500
• Employer match – $12,000

In this scenario your combined contribution to the pre-tax portion of the 401(K) account for the year would be $42,500.

But you still have the ability to contribute up to the $69k. This enables you to potentially contribute an additional $26,500 in after-tax dollars into the after-tax portion of the 401(K) account, if they have that account as part of their plan.

At that point, optimally you would convert the $26,500 from the after-tax account into the Roth 401(K) account within the employer-sponsored plan.

Now you can probably start to understand where the “Mega” comes into play with this strategy.

Key eligibility questions

Okay, you’re over 50 (maybe waaaay over), so you know that few things in life are easy or completely straightforward. That might be the case with a mega backdoor Roth IRA strategy, as there are definitely challenges and a caveat…or two.

To help determine if you can take advantage of this strategy, you need to ask three key questions.

• Does your employer-sponsored plan contain an “after-tax” account in their 401(K)?

Fact is that not all 401(K) plans do. If this is the case, you can’t take advantage of this strategy.

That said, Sharpe explained in his recent video on this strategy (check it out here) that you might be able to talk with your employer and attempt to convince them to make a change to their plan. He suggests going to HR or as far up the chain as possible and making the case.

He points out that by adding the after-tax account within their plan, it could enable employees to potentially turn tens of thousands of dollars into hundreds of thousands of dollars over time. This is obviously an extremely valuable employee benefit, so they may take action.

He goes on to point out that Oak Harvest has actually worked with clients and their employers in the past to get their employer-sponsored plans changed. This demonstrates this is a real possibility, especially if you are an influential high-income earner in the company.

• Does your employer’s plan contain a Roth 401(K) account?

If not, this strategy may have to be modified and accomplished after you eventually leave the company. More on that in a moment.

• Does your employer allow you to take “In-Service” (ISD) distributions within your plan?

An ISD allows you to take distributions while still working for the employer. If they do so, then you are eligible to move the money in the after-tax account into the Roth 401(K) account within the plan (assuming there is one) in the form of a conversion.

If the answer to all three questions is yes, great news! Done and dusted, as the saying goes… You should be eligible and able to take advantage of the mega backdoor Roth IRA strategy, which could prove quite lucrative over the long run.

If instead the answer to any of the 3 questions is no, you may run into issues in adopting this strategy.

The first question on the “after tax” account has already been addressed and will take some work, as detailed.

In the case of questions 2 and 3, if ISDs aren’t allowed, or there’s no Roth 401(K) account in the plan to roll/convert into, you might still be able to do the mega backdoor Roth IRA strategy, but you will have to wait until you leave the company to actually convert the after-tax contributions into a separate Roth IRA account you have set up.

If you do have to go that route, it’s important to know there is a critical caveat to be aware of.

The money contributed each year into the after-tax account of the 401(K) plan would accumulate over time, with potential new contributions being added every year until you leave. Say that is 10 years. The entire contributed amount would be eligible for conversion into a Roth IRA account you set up when you leave.

The $265k contributed over that period would remain tax-free going forward, as is the normal case with Roth IRAs.

But there would still be the issue of gains that would likely accrue (hopefully) during that period you remained at the company. The gains would need to be rolled into a traditional IRA at that point in order to maintain their tax-deferred status and for taxes to be avoided until later.

Example – you contribute $265k ($26.5k annually) over 10 years and earn $200k (gains) during that period. The $265k can be converted to the new Roth IRA upon separation from the company, tax-free going forward.

The $200k in gains is then rolled into an existing or new traditional IRA, where those funds remain qualified in a tax-deferred status. When eventual distribution does occurs from that traditional IRA account you will have to pay taxes (taxed as ordinary income) on the distributed amounts.

Conclusion

Wow. There are lots of moving parts and considerations involving the backdoor Roth strategy, no matter which route you take.

That said, obviously the potential benefits justify serious consideration if you are limited or precluded (ineligible) from making annual contributions to retirement accounts due to your high income.

If you are eligible to utilize either strategy, especially the mega backdoor version, you can materially increase your retirement savings in a short period of time.

Why wouldn’t you want to take advantage of this opportunity? For many who are eligible, the answer is probably the fact they seem complicated (that’s fair) and involve a lot of steps.

Too much hassle and the misguided belief there isn’t much bang for the buck in terms of the effort necessary.

But given this is a longer-term strategy, and the fact that the power of compound interest will work in your favor, the dollars we are talking about can easily reach into the hundreds of thousands.

In that light, you owe it to yourself to talk with someone who can help you determine if eligible and what to do to get started.

At Oak Harvest Financial Group we can be here for you as you address this issue, and more. To help you decide if a mega backdoor Roth IRA makes sense. Moreover, to help you navigate the often-difficult journey of retirement.

If you are currently utilizing a retirement plan (either your own or one created for you) our team would be happy to review it to determine if it is capable of really meeting your goals.

Or we can assist you by creating a retirement plan capable of helping you to retire with confidence. We can build a holistic, comprehensive retirement plan addressing relevant issues, utilizing strategies that cover taxes, income, spending, healthcare, legacy, and more, customized to your family’s specific needs.

A plan created with the goal of ensuring you can successfully live out the retirement you envision.

If you are ready to take the next step and talk to a team of retirement planners who can advise on all your retirement needs, and who will put your interests first, Schedule a call today!