We often talk about diversifying your retirement money’s tax exposure. We believe investors should have retirement funds that vary in tax treatment, including tax-deferred, tax-free, and after-tax non-retirement money. This tax diversification can help investors control their tax situation in retirement, preparing them for when they must take required minimum distributions, which are taxed at normal rates.
Unfortunately, high-income earners have few opportunities to save tax-free money. They earn too much to contribute to a Roth IRA. Traditional IRAs are often non-deductible, and 401(k) plans are generally tax-deferred savings. High-income earners usually take advantage of backdoor Roth IRA contributions—making a non-deductible IRA contribution and then converting the funds to a Roth account, but this is limited to $6,000 a year, or $7,000 for those 50 and older. If high-income earners have access to a Roth 401(k) at work, they may be able to contribute up to $19,500 ($26,000 for 50 and older) to the tax-free portion of their company-sponsored retirement plan.
However, there is a little-known strategy—the mega backdoor Roth IRA—that allows investors to sweep up to $58,000, or up to $64,500 for 50 and older, into a retirement account that grows tax-free. This “loophole” in the Roth conversion rules takes place in your 401(k).
To use this mega backdoor Roth IRA, you need three things: 1. a 401(k) plan that allows you to contribute up to the limit with after-tax contributions. 2. Your employer offers either in-service distributions to a Roth IRA or lets you move money from the after-tax portion of your plan into the Roth 401(k) portion. 3. You must have money left over to save, even after maxing out your regular 401(k) and Roth IRA contributions.
First an investor must contribute $19,500 (or $26,000 for 50 and older) to either their pre-tax 401(k) or Roth 401(k). Then the investor can contribute up to $38,500 more after tax to their plan to reach the contribution limit of $58,000 ($64,500 for 50 and older). Keep in mind that employer contributions to the plan count toward the contribution limit, so if you receive employer matching contributions, those funds will always be pre-tax.
Once the after-tax contributions are made to the plan, the investor can convert the money to a Roth IRA using an in-service withdrawal or convert it to the company’s Roth 401(k) option as soon as possible to minimize any tax-deferred growth on the money. Even if some tax is due on the increase upon the conversion, it should be significantly less than the several years of growth had the money remained in the tax-deferred account. Because this strategy is implemented within a 401(k), the pro-rata rules don’t apply, meaning the investor can choose to convert only the after-tax dollars to the Roth accounts.
There are several of nuances to this investment strategy, so working with a financial adviser and your 401(k) administrator is essential. However, with proper planning, high-income earners may have this unique opportunity to save a significant amount to Roth accounts and benefit from tax-free growth for many years.
If you want to explore if the mega backdoor Roth IRA conversion would work for your situation, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166
This article is for demonstrative and academic purposes and is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
