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The Mega-Backdoor Roth IRA

Updated: Jun 4, 2021

Money contributed to your Roth IRA comes from “after-tax” dollars, meaning you will have already paid income tax on any money that goes into your Roth IRA account. Because you already paid taxes on that income before contributing it to your Roth account, that money will grow tax-free and come out tax-free when you withdraw it in retirement.

If you choose to place your savings in a traditional IRA account, you are using pre-tax dollars. This can be an effective way to lower your taxable income in your working years, but this approach may significantly increase your lifetime tax liability as it simply delays the inevitable tax bill.

The delayed tax bill may be substantially higher than today’s bill if tax rates rise. Combining the shifting political climate in America with our rising national debt, it’s reasonable to assume that tax rates could be significantly higher in years to come.

Backdoor Roth IRA Explained

The idea of tax-free withdrawals from the Roth IRA is obviously appealing, but Congress has set contribution limits along with income limits on who can contribute to a Roth IRA. In 2021, you are ineligible to contribute to a Roth IRA account if you earn:1

  • $140,000 or more as a single filer

  • $208,000 or more as a joint filer

For savers with incomes above the Roth IRA thresholds, the backdoor Roth IRA is an option that allows high earners to bypass the income limits and still utilize the tax advantages of a Roth IRA. Here are the basics to creating a backdoor Roth IRA account:

  1. Open a traditional IRA and make a non-deductible contribution to your IRA.

  2. Convert your traditional IRA to a Roth IRA account (your account administrator will provide the necessary paperwork and instructions to do this).

  3. You will want to roll your traditional IRA to a Roth IRA as soon as possible to minimize the tax implications on the gains from your investments.

What Is A Mega Backdoor Roth IRA?

A mega backdoor Roth IRA is a more-complex strategy that allows high earners to shift up to $38,500 into a Roth IRA or Roth 401(k) account on top of their regular contributions. This option is not available to everybody, as some 401(k) plan providers do not allow it, and it is reduced by the amount of employer contributions made to your 401(k).

If you’re considering this option, you will want to work with Monotelo Advisors or a qualified CPA to identify any unexpected tax bills and to determine if this is in your best long-term interest.

How Does a Mega Backdoor Roth IRA Work?

In order for a mega backdoor Roth IRA to work, your employer must allow you to make after-tax voluntary contributions to your 401(k) account. These contributions would come from separate savings, and they would not count toward your 401(k) contribution limit. You’ll want to check with your human resources department or plan administrator to determine whether this option is available to you.

Next, you will need your 401(k) plan to allow you to move your after-tax contributions from your 401(k) plan to the Roth 401(k) portion of your plan or a Roth IRA account.

If your plan does not allow for in-service withdrawals, it dramatically reduces the benefit of the backdoor Roth, as it shortens the amount of time your money can grow tax-free.

Who Does a Mega Backdoor Roth IRA Work Best For?

Mega backdoor Roth IRAs are a little more complicated and require a few more steps to implement, so this strategy is not a fit for everyone. This strategy is most useful for those who

  • Max out their regular contribution limits

  • Earn too much to be eligible for a Roth IRA

  • Have extra cash sitting on the sidelines

  • Already addressed their other key financial goals like establishing an emergency fund or paying down debt

  • Are in plans that allow for after-tax contributions and in-service withdrawals

If you don’t fit the description above, you may be better off utilizing a Roth IRA account or a Roth 401(k) if available to save for retirement.

If you think a mega backdoor Roth IRA is an option worth considering, reach out to Monotelo Advisors and we will help you determine what is in your best interest.

This content is developed from sources believed to be providing accurate information, and provided by Monotelo Advisors, Inc. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.

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