By Chris Heisten, CRPC®, CFP®, CSRIC®
Retirement planning can be a complex endeavor, especially when it comes to maximizing tax advantages while building your nest egg. For high-income earners especially, your income might be too high to contribute to certain accounts like a Roth IRA, and you might go over the 401(k) contribution limits, yet still have more to invest. If that describes you, there’s one exciting strategy that could help you invest more in a tax-advantaged way: the mega backdoor Roth. In this article, we’ll discuss what it is, who it’s suited for, and the pros and cons of implementing it for yourself.
What Is a Mega Backdoor Roth?
Both traditional and Roth IRAs have contribution limits that are set by your income. For the Roth IRA in 2023, if you earn over a certain amount, you simply cannot contribute directly to that account. In 2023, if you file your taxes as single, the maximum modified adjusted gross income (MAGI) you are allowed to have is $153,000; if you file jointly with your spouse, that number is $228,000.
However, the mega backdoor Roth strategy allows you to bypass this limitation, and instead use the after-tax contribution limit for employer 401(k) plans, which is $66,000 in 2023.
How Does a Mega Backdoor Roth Work?
There are a few separate steps you need to execute to make a mega backdoor Roth contribution correctly. To clarify the process, consider what you need to do to make a backdoor Roth contribution (which is separate from a mega backdoor Roth): initially, you make contributions to a traditional IRA using pre-tax funds ($6,500 for people under 50, and up to $7,500 for individuals aged 50 and above), and subsequently, you convert those funds to a Roth IRA to benefit from tax-free growth. When you convert those funds, you are liable to pay taxes on both the original contributions and any earnings accumulated in the IRA.
The mega backdoor Roth strategy follows a similar principle to indirectly fund a Roth account, but with a slight variation. Instead of using a traditional IRA, this strategy involves utilizing a 401(k) as the initial step. In 2023, the maximum allowable contribution to your 401(k) is $66,000 (or $73,500 if you are aged 50 or above), encompassing pre-tax, after-tax, and employer matching contributions. Once you have reached the limit for your pre-tax 401(k) contributions, the subsequent step involves making after-tax contributions up to the annual threshold.
Following this, you can transfer the amount of your after-tax contributions to a Roth IRA. During this conversion, you will only be required to pay taxes on the pre-tax contributions and any earnings that have been accrued. Once the funds have been successfully converted, they will grow tax-free and be exempt from future required minimum distributions (RMDs).
How Is a Mega Backdoor Roth Different Than a Backdoor Roth?
While both approaches involve contributing to a Roth account, the key distinction lies in the contribution limits. The backdoor Roth strategy adheres to IRS limits of $6,500 for individuals under 50, with an additional $1,000 catch-up contribution for those aged 50 and above. On the other hand, the mega backdoor Roth permits significantly higher limits up to $66,000.
Thus, the mega backdoor Roth is best suited for high-income earners looking to maximize their retirement savings that have access to after-tax contributions in their company 401(k). If you aren’t sure you have that feature in your 401(k), consult with a financial professional (including one of the fiduciary financial advisors at Heisten Financial) to review your plan and see if this is a viable option.
Mega Backdoor Roth Pros & Cons to Consider
There are several advantages to utilizing the mega backdoor Roth strategy. First, the ability to make after-tax contributions in your 401(k) and convert them to a Roth account allows for tax-free growth and withdrawals during retirement, which could be a significant advantage in terms of tax savings. Additionally, the mega backdoor Roth enables individuals to surpass the contribution limits imposed on traditional pre-tax and Roth IRA contributions, empowering them to accelerate their retirement savings. Lastly, funds in a Roth IRA are not subject to required minimum distributions, allowing you to have more flexibility in retirement in terms of where you take your distributions.
However, it is important to be aware of a few things before you start this strategy. Not all retirement plans offer the option for after-tax contributions or in-plan conversions to a Roth account, which means that the availability of the mega backdoor Roth strategy will depend on the specific plan provisions at your company.
Furthermore, there could be regulatory changes that could impact the availability and viability of the mega backdoor Roth strategy in the future. While the strategy is currently permissible, there is always a possibility that laws may change, potentially affecting the eligibility or effectiveness of this approach. Stay informed of any changes in tax laws, and consult with a financial professional before implementing this on your own.
Does a Mega Backdoor Roth Make Sense in Your Financial Plan?
Maximizing your retirement savings while making tax-smart decisions is a key component of how we do financial planning. However, there is no one-size-fits-all solution for everyone, especially when you factor in the nuances of the tax code and the specifics of your company’s retirement plan.
At Heisten Financial, we work with our clients to thoroughly understand their unique circumstances, and then recommend and implement strategies we believe to be the best. That might include a mega backdoor Roth—but it might not. Either way, you should have a tax-smart plan to pursue your retirement goals. If you don’t, or are looking to improve what you already have, we’d love to see if we can help. You can schedule a complimentary assessment to get started.
Chris Heisten is the President and Founder of Heisten Financial LLC, a fee-based boutique financial planning firm with the focus of giving clients back their time so they can spend it doing what’s most important to them. Acting as a true fiduciary for his clients, Chris aims to solve their financial pain points and move them toward financial freedom. In the financial industry since 2007, Chris partners with business owners and oil workers on their journey through life, striving to instill calmness and a sense of direction as he simplifies the complex. He loves nothing more than seeing clients experience relief when they achieve what they thought was impossible.
Chris graduated from the University of Maine, where he played hockey on a scholarship, and retired from professional hockey in 2007. In the community, he remains engaged serving as a youth hockey coach. Chris holds the CERTIFIED FINANCIAL PLANNER™, Chartered Retirement Planning Counselor℠, and Chartered SRI Counselor™ designations. Outside of the office, he enjoys trying new food and wine, reading, traveling, playing golf and hockey, fat tire biking, and donating to local charities. His passions include being a husband and dad, lake life with the family, watching his son and daughter play sports, and spending time with his wife. To learn more about Chris, connect with him on LinkedIn.