Roth IRAs are great investment vehicles because they allow individuals to enjoy tax-free growth and withdrawals for retirement. And, as mentioned in a previous blog post, converting pre-tax dollars to after-tax Roth accounts can be extremely beneficial for the long-term investor. Outside of conversion, however, contributions to Roth IRAs are fairly restricted:
- For investors under 50, contributions are limited to $6,000 in 2020.
- For higher earners, they are restricted if income is too high: Contributions are phased out starting at $124,000 for individuals and at $196,000 for married couples.
Making After-Tax IRA Contributions with a Backdoor Roth IRA
In the case of conversion, a “backdoor” Roth IRA contribution is often a good strategy. However, if pre-tax IRA balances exist, then a pro-rata rule applies, which diminishes the tax benefit. A backdoor Roth IRA allows an after-tax traditional IRA contribution, regardless of income, and subsequent conversion to a Roth IRA without any tax consequences.
Again, this is a good strategy, but it’s limited in the amount of permissible annual contributions, which are the same as those for the Roth IRA: $6,000 in 2020.
Deferring Salary with a Roth 401k
Enter the Roth 401k. If your employer has this option, allocating your retirement savings to a Roth 401k might be a good option. Like regular 401k contributions, you can defer part of your salary to these accounts, but instead of contributing pre-tax, you make it after-tax. The advantage over Roth IRAs is the annual amount of contributions—$19,500 in 2020—and the lack of phase-outs for high-income earners.
While the additional savings opportunity is great for Roth 401k savers, many high-income earners would prefer to save even more on a tax-free basis. A less common technique, known as the “mega backdoor Roth,” might be an option in this case.
More Tax-Free Saving with a Mega Backdoor Roth
You may be eligible for a mega backdoor Roth if these plan features are present:
- You participate in a 401k plan at work that allows after-tax contributions.
- The 401k plan allows in-service distributions to a Roth IRA or transfer of funds out of the after-tax portion of the account into a Roth 401k.
With this mega backdoor Roth strategy, you may be able to contribute an additional $37,500 in 2020 on top of the regular plan contribution limits. This contribution amount is reduced by any employer contributions. Then, this after-tax portion is immediately converted to the Roth 401k or withdrawn and transferred to a Roth IRA. So, if you do have access to a Roth 401k, this equals a $57,000 annual contribution that can grow tax-free with tax-free withdrawals in retirement.
Things to Consider with a Mega Backdoor Roth
Unfortunately, a mega backdoor Roth is less common for a few reasons, including:
- Fewer than half of 401k plans allow after-tax contributions. These are becoming less common as more Roth contributions are being offered instead.
- The plans may not allow in-service withdrawals or transfers. Even if a plan offers after-tax contributions, it may not allow in-service withdrawals. The employers are not obligated to offer either of these options in their 401ks.
- There is the problem of IRS non-discrimination rules that limit the amount of after-tax contributions that high earners can make based on the contribution amounts made by lower-income earners. So, in practice, many plans don’t offer this option for this reason. The solo 401k is an exception though, as they are for the self-employed and of course not subject to IRS non-discrimination rules.
The bottom line is that the mega backdoor Roth strategy is extremely beneficial if available to you, but setting up this strategy is complicated, with many moving parts and the potential for unexpected tax bills. As such, we recommend consulting your financial advisor and 401k plan sponsor for guidance.