Mega "Backdoor" Roth: Cheesy Name, Serious Savings



There are several ways to save for retirement. Some of the most common ways are through your company’s 401(k) or an Individual Retirement Account (IRA). Additionally, there are two ways you can contribute to either account 1.) on a pre-tax basis and 2.) on an after-tax basis, better known as Roth contributions. I won’t go into the history of Roth conversions, but let’s just say that congress decided to lift the income restrictions a little over a decade ago allowing high-income earners to convert more money into their Roth accounts.


How does the Mega “Backdoor” Roth work


In order to execute a Mega “Backdoor” Roth conversion, you’ll need a few things. The first is a 401(k) plan. The second thing needed is the ability to make both Roth contributions and After-tax contributions. Wait, aren’t Roth contributions already considered after-tax? Yes, they are. The After-tax contribution bucket is considered the 3rd bucket in your 401(k). One that can be filled after you have maxed out your employee contributions. This After-tax bucket can only be filled to reach the maximum contribution amount allowed in a 401(k); in 2022, the maximum deferral amount allowed in a 401(k) is $61,000


This means that if you set aside $20,500 as an employee (the employee max in 2022), you are able to fill the after-tax bucket with $40,500 of your hard-earned dollars minus any company match contributions.


The last and final piece missing is the provision in your 401(k) plan that allows “in-plan” conversions. This is the provision that will allow you to convert your After-tax 401(k) contributions into your Roth 401(k) bucket.


How are my taxes affected?


Generally speaking, the idea is to convert your After-tax contributions IMMEDIATELY into your Roth 401(k) account. Why? If you fail to convert your contributions immediately then you have to pay tax on the earnings of your after-tax contributions. This can be avoided by an immediate conversion since the initial contributions are considered after-tax with little to no earnings.


When should I consider implementing the Mega “Backdoor” Roth strategy


You should consider performing a Mega “Backdoor” Roth conversion if you have maxed out your employee contributions and can still funnel more money into retirement savings. It makes no sense to go through a Roth conversion if you haven’t maxed out your Roth 401(k) directly first.


When should I pass up the Mega “Backdoor” Roth strategy


While I’m a fan of tax-free growth and it makes total financial sense if you have the discretionary income to add more to your retirement savings, I generally do not recommend this strategy to individuals that have near-term goals to meet, such as buying a home or rental property, buying into a professional practice, or even paying taxes on equity compensation where you may need more liquidity.


So why the cheesy name?


Well, typically when people think of a “Backdoor” Roth conversion it has to do with an Individual Retirement Account (IRA). IRAs are capped at contributions up to $6,000 in 2022. If you’re able to contribute 6, almost 7 times more, then I’d say it’s a Mega contribution too. Though I would prefer something like “Super Backdoor Roth” instead! Sounds catchier, in my opinion.


Mega Backdoor Roth, MyLife Financial Sketchart

 

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MyLife Financial is a fee-only financial advisory firm providing objective and independent advice virtually. Our clients are busy professionals that face daunting questions of how today's financial decisions will affect their long-term financial success. Everything written is strictly for informational use only. Please seek the advice of your CPA, Attorney, or financial professional before implementing any strategies.

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