If you want to supersize your retirement savings for early retirement or help you make up for lost time, consider a mega backdoor Roth. It can allow you to stash up to another $37,500 into retirement savings, which will grow tax-free. In an environment where taxes may go up because of government debt, this can be a very worthwhile proposition. It is especially beneficial for earners that make too much to contribute to a regular Roth or have too much in IRA assets to do a regular backdoor Roth. Of course, there are hurdles and restrictions.
The first hurdle is maxing out your 401(k) or Roth 401(k) contributions. In 2020, the limit is $19,500, or $26,000 if over age 50. If you aren’t contributing enough to hit these thresholds, then a mega backdoor Roth doesn’t apply. If you are hitting these thresholds, then your normal contributions should probably be pre-tax, and the backdoor Roth can serve as your after-tax savings. (It may not make sense to put all of your contributions into the Roth bucket if you are taxed at 37% federally.)
If you earn less than $124,000 or $196,000 filing jointly, then you are still eligible to contribute to your normal Roth IRA. Make that contribution first, which can be $6,000 or $7,000 if over age 50. If you earn more than the limits, then a mega backdoor Roth is your only retirement savings option.
The next big hurdle is your 401(k) plan. Only 43% of companies allow for after-tax contributions. In addition, the company 401(k) plan needs to allow for in-service distributions into the Roth. If the plan checks both of these boxes, then the contributions go into the after-tax portion, and the plan administrator can convert those assets into a Roth.
If the plan doesn’t allow for in-service distributions, then you can still put money in after-tax, but the earnings will only be tax-deferred. Usually at age 59½ or at retirement, you can place the after-tax portion into a Roth IRA, and the tax-deferred portion can go into a traditional IRA. This somewhat defeats the purpose as the goal is to get as much as possible into a Roth as soon as possible to allow for tax-free growth.
If you have jumped over these hurdles, then you are ready to stash money away. In 2020, you can put a maximum of $57,000 into a retirement plan, including your contributions and the company’s match. So, if you put in $19,500, and the company matches $5,500, then you can put in up to $32,000 more in the mega backdoor Roth. Talk about supersizing your retirement savings!
The major benefit of a mega backdoor Roth over a regular backdoor Roth conversion is not having to deal with the pro-rata rule. In a normal backdoor Roth, whatever you convert is proportionate across all of your IRAs. So, if you have any sizable amount in pre-tax IRA (i.e., traditional IRA), then you have to convert and pay taxes on the proportional amount converted from the IRA. Depending on the size of your IRA, and if you are under age 59½, this can really hurt. Since the mega backdoor Roth takes place in a 401(k), that pro-rata rule doesn’t apply.
While there are hurdles and restrictions, the mega backdoor Roth can be a great way to supersize your retirement savings. If you have any questions on how this can help you reach your goals, please contact our Private Wealth Managers.