How the Mega Backdoor Roth Can Help You Save Thousands Long-term in Retirement
The mega backdoor Roth IRA could put hundreds of thousands of dollars of tax-free money inside your retirement accounts, but what exactly is it? Who should consider it? Who would benefit from it? What are some of the pitfalls that you need to make sure you avoid?
Backdoor Roth IRA vs. Mega Backdoor Roth IRA
Point of clarification here, because we actually have two strategies, completely different, that sound similar, have some of the same concepts, but either one or both may or may not be appropriate for you and your situation. We have the backdoor Roth IRA, and then we have the mega backdoor Roth IRA. We’re going to cover both, get into some of the limitations and benefits, but I want to start with the backdoor Roth IRA. We did a video last week where we talked about some confusion between Roth IRA contributions and Roth IRA conversions.
I encourage you to watch that video as a supplement to this one just to increase your knowledge base. As a refresher, if you file taxes as a single person, if you make over $161,000 of modified adjusted gross income, which is essentially your gross income, then you typically would subtract out what we call some above-the-line deductions. You have to add those back in to get to your modified adjusted gross income to determine your Roth IRA contribution eligibility. I would recommend that you work with a CPA to help figure this out, because MAGI, modified adjusted gross income, there are several different calculations for it in the tax code, depending on what benefit or subsidy you’re trying to qualify for.
Navigating Income Limits for Roth IRA Contributions
For Roth IRA contributions, where we take money from the bank and put it into the Roth IRA, if you make over $161,000 of MAGI, modified adjusted gross income, you are ineligible to contribute to a Roth IRA. You can convert money from an IRA to a Roth, but that’s some of the content we covered in that supplemental video. If you file jointly and make over $240,000, you are ineligible to contribute to a Roth IRA. If you fall into either one of these situations, the backdoor Roth IRA contribution may be of interest to you. Now, if you have income in-between these two thresholds, you have a phase-out.
You are eligible to contribute, but it’s a reduced amount. If you make less than either one of these amounts, filing single or married, then this strategy, the backdoor Roth IRA, isn’t appealing to you, because you can just put money into a Roth IRA the normal way. Go through the front door. Okay. You make more than the income limits that we just talked about. Here is what it looks like to complete the backdoor Roth IRA contribution process. You take money from your bank, and then you put it into a normal IRA. If you make more than those amounts, you’re not eligible to contribute to a Roth IRA, but you’re also not eligible to deduct the contribution that you put into an IRA.
This is what’s known as a non-deductible contribution. No tax deduction for this money going from your bank account into that IRA. Now, if you’re over the age of 50, you can do a $1,000 catch-up contribution. This is actually $8,000. You then take that money from the IRA that you did already pay taxes on, because you don’t get a deduction for it, and then you simply move it over into the Roth IRA. Because you didn’t get a deduction on putting the money into the IRA, you don’t have to pay any taxes on the contribution amount that goes into the Roth.
Now, if you leave it there for some time, and it grows in value, that increase in value, the gain, if you convert all of it, you will pay tax on that. That’s a conversion now. The whole thing is actually conversion. When we’re converting dollars that are considered to be after-tax that we did not get a deduction for, we simply don’t pay taxes when we move that money to the Roth IRA. Any gain that was achieved during the holding period here, that will be subject to taxation. You can see it’s a bit of a slower process with the backdoor Roth IRA, because we can only put $7,000 or $8,000 in per year.
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Over time, I want to point out just how valuable this could be for maybe you or a child or a grandchild. I have just $7,000 a year going into this account for 30 years, averaging 8%, compounding annually the future value, $792,000. That’s $210,000 worth of actual contributions into that account. Because of the compound interest of 8%, it has a future value of $792,000. Now, if markets perform much better than that over time, now at 10%, we’re looking at $1.151 million from just doing $7,000 a year for 30 years. Obviously, this would be somebody younger, so maybe you teach your son, daughter, grandchild about this.
I just want to preach for a second about the importance of consistency. The true value in investing is achieved over multiple years of discipline and allowing that eighth wonder of the world, compound interest, to work for you, not against you like it does with debt. That’s the basic of what the backdoor Roth IRA is, and some of the benefits if you are consistent with this strategy over many, many years. You need to be aware of a couple of key components because this may preclude you from considering or even wanting to do the backdoor Roth IRA.
The Pro-Rata Rule in Backdoor Roth IRA
You have to file form 8606 every single year because this is going to communicate to the IRS about the non-deductible IRA contribution, and then also the conversion over to the Roth IRA. You have to be aware of this pro rata rule. The form 8606 becomes extremely complex and you have to keep track of it. I just personally would not do this myself if you have other dollars already inside an IRA. The pro rata rule essentially says all IRAs are treated as one. It’s called the IRA aggregation rule for the purpose of this backdoor Roth IRA contribution.
As an example, if you have $200,000, let’s say it was from an old 401(k) that you no longer work there, you roll that into an IRA. Now you have a new job, your income limits are above that which you would qualify to make a normal Roth IRA contribution, so you want to consider the backdoor Roth. You put $8,000 into an IRA, or I guess some people may, I’ve seen this before, put it into this same IRA. You can’t do this, or I guess you can do it but the calculation doesn’t work the same because of this pro rata rule. The IRS says all of these IRAs are essentially one.
We have to take the total amount of money that we have in IRAs, the amount that we’ve moved over to a Roth as a conversion, normally this would have been a tax-free movement because we did not get a deduction for this $8,000, but here since we have this other money in the IRA, we have to divide 8,000 by 208, we get 3.8%. That is the amount that is tax-free on this conversion of this $8,000, meaning 96.2% of this $8,000 that you move into the Roth is subject to income tax.
Even though you pay taxes on the $8,000 because it’s a non-deductible contribution in this hypothetical scenario where you weren’t aware of the pro rata rule and you put the money into an IRA or you put it into your existing IRA, the IRS is saying you can’t just isolate out that $8,000 that you put in and then convert it because of this pro rata rule. In the industry, we call it, you can’t take the cream out of the coffee once it’s all been mixed together. In my opinion, it does not make sense at all to consider the backdoor Roth IRA if you already have money inside an IRA because of this aggregation rule.
Now, if you have money in a 401(k), 401(k)s are not considered part of this IRA aggregation rule. If you had $200,000 and this wasn’t an IRA, it was a 401(k), you could still do this because 401(k)s are not included in this IRA aggregation rule. Bonus tip, the IRA aggregation rule actually works in your favor once you get to required minimum distribution age because again, the IRS considers all IRAs to be one. If you have two different required minimum distributions, you don’t have to take them from each. You can take them all from one IRA. Your RMD for both is considered satisfied as long as you’ve taken the appropriate amount, which can help with retirement income planning and tax planning down the road.
Now, the mega backdoor Roth IRA. I don’t know who coined this term. I did not become aware of the term itself until maybe five or six years ago, but we’ve been helping clients do this for some time. Ultimately, what the mega backdoor Roth IRA contribution is is putting an excess amount into the after-tax part of your 401(k) and then eventually moving that into a Roth IRA. The contribution limits, meaning the amount of money you can put into your 401(k), is much higher than an IRA. This is why they call it the mega because you’re able to get more money in there more rapidly.
I want to walk through an example with you. Let’s say you’re a high-income person making $300,000 a year, and your 401(k) match is 100% of your contribution up to 4% of your salary. If you put in up to $12,000, 4 times 300, your company will match 100% of that. In 2024, the maximum amount of money that you can put into a 401(k) is $69,000. Theoretically, if you didn’t do any pre-tax contribution, you could put $69,000 into the after-tax part, move it into a Roth IRA. This example, we’re going to take advantage of the tax deduction and also make sure we get that employee match.
$69,000 is the total amount of money maximum from you and your employer that can go into a 401(k) in 2024. The maximum deductible amount that you do not pay income taxes when you put it into your 401(k) is $30,500. If you’re less than 50, it’s actually $23,000. Again, there’s a catch-up contribution about or exactly $7,500 if you’re over the age of 50. The most you can deduct is $30,500. When your employer matches, that match must go into the pre-tax part of your 401(k). It can’t go into the Roth. It can’t go into the after-tax account.
$300,000 salary, 4% match. The law says the most we can put into a 401(k) is $69,000. Of that, the most you can take an income tax deduction for is $30,500. We’re going to look at John who’s over 50. Decides to max out his pre-tax contribution, $30,500. He gets the match of $12,000. He’s put $42,500 into essentially the pre-tax part of his 401(k). Employer did $12,000, he did $30,500. The maximum 2024 contribution into a 401(k), that was $69,000. We take the $69,000, subtract out what’s went in already. Which leaves $26,500 still eligible to go into the 401(k), but you cannot take a tax deduction for that.
Many 401(k)s have an after-tax account. We take that $26,500 and we put it into the 401(k). Your 401(k) may or may not have these three components, but it’s important to understand that essentially it’s all one account. Technically it’s three different accounts, but it’s all one 401(k). You don’t have to fill out more paperwork or do more things. You have options. I recommend talking to someone at either the plan administrator or your HR department. This little diagram helps visualize it, I think. You have the pre-tax part, $42,500 went in.
He puts $26,500 into the after-tax part of the 401(k). Then typically immediately, you would take that $26,500. If you’re eligible to do an in-service distribution into a Roth IRA if it’s allowed at your company This is what the mega backdoor Roth IRA contribution is it’s taking money From the after-tax part of your 401(k) and moving it in to the Roth IRA or Roth 401(k).
Limitations and Pitfalls of Backdoor Roth IRA
What are some limitations here? What may stop you from doing this? First and foremost, some companies don’t have an after-tax part of the 401(k), so you’re not eligible to do this.
If that’s the case, I would go to your HR department, I would go to your boss. I would try to go as far up the chain as you possibly can and say, we have a pretty outdated 401(k) here. Can you guys consider doing something that would benefit us employees? Because if you are a high earner, the ability to get tens of thousands of dollars, which will turn into hundreds of thousands of dollars over time into this account then over into the Roth, that’s an extremely valuable employee benefit. We’ve actually worked with clients and some of the biggest companies in the world to change their entire 401(k) because they weren’t eligible to do this.
I know they’ll do it. Just sometimes it’s like moving a big old boulder and you understand how it is with big corporations. If you work for a small company or if you’re a business owner, much more easy to get this accomplished if you don’t have these options inside your 401(k). The first thing, you need to have an after-tax option inside your 401(k). You then need to have a Roth option inside your 401(k).
Requirements for In-Service Distributions
Finally, you have to be eligible to do an in-service distribution, which means prior to severing from service, you’re allowed to move money from your after-tax part of the 401(k) into the Roth part of the 401(k).
If you can’t do that in-service distribution, this could still make a lot of sense, but you just have to wait to sever from service before you can actually take these after-tax dollars and move it into not a Roth 401(k), you would simply move it into a Roth IRA. In that situation, this money inside the after-tax part, it’s going to be growing. Let’s say you did this for 10 years. You put $265,000 in. Then you had $200,000 of interest gain on these after-tax dollars. When you sever from service, you would take the contributions that you’ve made, $265,000, you roll that into a Roth IRA outside of your 401(k).
All of those gains, let’s say the $200,000, that would then be rolled into a traditional IRA to maintain that tax deferred status. Otherwise if you roll it into the Roth the whole account, you’re going to pay taxes on that $200,000 that’s accumulated that you’ve yet to pay taxes on because it is tax deferred. What are the questions you need to go to HR and ask? Do we have an after-tax account in the 401(k)? Do we have a Roth account inside our 401(k)?
Are in-service distributions allowed to convert from the after-tax to the Roth 401(k) part? If Any of these answers are no, then you may not be able to complete the mega backdoor Roth while working. As long as you have the after-tax account, you can still get money into that after-tax account, make all those big contributions. Then when you retire, roll that money into a Roth IRA.
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