The ‘Mega Backdoor Roth’
and Two More Ways to Benefit from a Roth IRA Under New Tax Law
Roth IRAs have long been popular, but recent changes in tax law are making them even more enticing. Even if you’ve been under the impression that you earn too much to take advantage of a Roth, there may be ways to utilize them.
Let’s start with the new lower income tax rates: these are set to expire in 2025, but they make any conversions to a Roth IRA even more favorable in the meantime because you’ll pay less tax on these conversions, plus qualified distributions from your Roth IRA in retirement are income tax-free.
Now, it’s true that income restrictions can prevent you from contributing directly to a Roth IRA. The thresholds are incomes exceeding $137,000 for a single person and $203,000 for a married couple filing taxes jointly. The good news, though, it that there are actually three indirect ways you can still fund a Roth IRA even if your income exceeds the specified limits.
Indirect Funding Mechanism #1: The Mega Backdoor Roth IRA
To take advantage of this strategy, you will first make the maximum tax-deductible contribution to your 401(k), which is $19,000 per person for 2019. This rises to $25,000 if you are over age 50 and are making so-called “catch up” contributions. However, here’s what you may not know: if your employer allows you to make after-tax contributions on top of that tax-deductible cap, you can legally exceed the cap and contribute up to $56,000 total for the year.
Why is this a wise strategy? Well, the answer is two-fold:
- First, contributing after-tax dollars to your 401(k) means they will still grow tax-deferred and you’ve got a greater amount of your money invested and growing, even if the earnings will be taxed a second time if withdrawn.
- Second, after-tax dollars contributed to your 401(k) can later be rolled over into a Roth IRA when you retire. So, if your current income means you don’t qualify for a Roth, this is a way to take advantage of Roth benefits after the fact. At this time, there are no income thresholds to worry about if you want to make after-tax contributions to your 401(k) with plans to roll them into a Roth IRA at a later date.
Let’s take a look at an example:
For our purposes, Judy is 55 years old and contributes the maximum $19,000 to her 401(k), plus the catch-up for a total of $25,000 in contributions. Let’s say she has additional opportunity to save this year because her children are now supporting themselves, and she likes the idea of funding a Roth IRA and having some retirement income that would be tax-free. Unfortunately, Judy’s income is too high to fund a Roth directly, so she takes advantage of the Mega Backdoor Roth instead. She chooses to save an extra $15,000 through after-tax contributions to her 401(k), where there are no income limitations imposed to thwart her retirement savings plan.
Let’s say Judy is able to save an extra $15,000 per year for the next three years, allowing her to amass after-tax 401(k) contributions totaling $45,000. When she retires, she will be able to roll this entire amount into a Roth IRA and receive distributions tax-free.
In essence, this strategy allows Judy to eventually save more in a Roth IRA than if she had qualified to directly fund a Roth in the first place. This is because she would have been subject to the Roth’s annual maximum contribution of $7,000 in 2019 for someone over age 50, whereas she was able to save much more than that on an annual basis by utilizing the Mega Backdoor Roth to contribute after-tax dollars to her 401(k) instead.
One note of caution when using this strategy: you’ll need a certain amount of liquidity to make this work. Don’t make greater after-tax retirement contributions if it will compromise your ability to maintain a solid emergency fund of cash for use as needed. Remember, any money that goes into your 401(k) will be off-limits until you are 59 and a half, and subject to steep penalties if you need to access it earlier than that. So, be certain you’ll still have access to all the cash you may need before opting for the Mega Backdoor Roth.
Indirect Funding Mechanism #2: Backdoor Roth IRA
You can take advantage of the same principles as the Mega Backdoor Roth on a smaller scale by utilizing a non-deductible IRA. In this method, if your income prohibits you from directly funding a Roth IRA, you can deposit the maximum annual amount of $6,000 (plus an additional $1,000 if you are over age 50) into a non-deductible IRA. The final step is to then immediately convert your non-deductible IRA into a Roth IRA where you can access your money tax-free.
This particular strategy works best if you don’t have a traditional IRA because you will be subject to the pro-rata rule otherwise. This is the regulation that requires aggregation of all existing IRAs when determining how much income tax you will owe upon conversion. So, if you don’t have any other IRAs besides a non-deductible IRA, converting it will mean you only owe taxes on any earnings.
Indirect Funding Mechanism #3: Convert a Traditional IRA to a Roth
Be cautioned, this strategy won’t make sense for everyone. Really, it’s only a smart option if you think your income tax rate will be higher in the future. So, if you’re someone who benefited from the 2017 tax cuts but fears moving back up into a higher tax bracket when the cuts expire in 2025, this option may not be best for you.
You won’t be subject to any income limits when converting a Traditional IRA or a pre-tax IRA to a Roth, but you will be subject to income tax on the full amount converted. For example, if you have a $200,000 Traditional IRA of pre-tax dollars and you convert it to a Roth, you’ll automatically have additional taxable income of $200,000. So, if you can’t do this before 2025, it likely won’t make sense.
One thing to know, however, is that the IRS actually allows you to space-out an IRA conversion. So, if you break that $200,000 down into six chunks of $33,333 and convert a portion each year for six years until the tax cuts expire in 2025, you’ll lower your amount of taxable annual income and potentially be able to avoid entering a higher tax bracket due to the conversion.
You may be wondering why it would make sense to convert a Traditional IRA to a Roth with so much incurred tax liability, and there’s one major reason: a Roth IRA has no required minimum distributions, unlike a Traditional IRA, which requires you to take money out each year after age 70 and a half. By contrast, your Roth IRA can just keep growing as long as you’d like it to. This allows you the flexibility to never use it if you’d like to leave it to your children. (Roth inheritance rules would require your kids to take a distribution, but the principal can continue to grow tax-free.)
Let’s sum up the advantages of converting a Traditional IRA to a Roth:
- There is no required minimum distribution at age 70 and a half.
- You’ll be subject to lower tax rates.
- Contributions (not earnings) can be withdrawn tax-free and penalty-free at any time and at any age.
- You won’t pay a 3.8 percent net investment tax.
- You could realize considerable tax savings over the long-term.
On the other side of the coin, here are a few disadvantages to this strategy:
- Conversion may move you into a higher tax bracket.
- You’ll pay an upfront tax bill upon conversion.
- You may trigger the 3.8 percent net investment tax.
Final Thoughts on the Roth IRA
Roths are a popular investment vehicle for a reason – they truly provide you with a powerful tool for financial planning. Your qualified withdrawals will always be completely income tax-free, and you won’t be forced into taking government-directed required minimum distributions.
Even if you cannot directly fund a Roth IRA due to income limits, new strategies for backdoor funding make this type of account accessible to more people.
If you think a Roth IRA would be in your best interest, start taking steps now to make it happen. Even a series of small steps taken consistently over time can yield tremendous value in the long-run.
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About the Author
As a Co-Founder, Craig brings years of hands on experience helping clients make informed investment and financial planning decisions. Craig takes great care in understanding his clients near and long term goals and implements an investment strategy around those goals.