The Roth IRA was originally established in 1998 through the Taxpayer Relief Act of 1997 and originally allowed investors the opportunity to contribute $2,000 per year. The benefit of the Roth IRA would not allow for an immediate tax deduction (unlike its Traditional IRA cousin), but earnings in a Roth IRA grow tax-free and the earnings could later be withdrawn tax-free at retirement.
Because of income and tax filing status restrictions, many individuals were not able to take advantage of a Roth IRA when it was first rolled out. The 2006 Tax Increase Prevention and Reconciliation Act (did not take effect until 2010) included a change that had previously prohibited Roth IRA conversion; a unique ability to move money from a traditional or post tax IRA into the Roth IRA and pay any necessary taxes associated with that conversion.
The creation of the Roth IRA & Roth Conversion along with other technical changes paved the way for the mega backdoor Roth.
What’s Needed for a Mega Backdoor Roth?
- After Tax Contributions – Many individuals are aware of the 401k contribution limit of $19,500 ($26,000 for those age 50+) in 2021, but many less are aware that some 401k plans allow for ‘after-tax contributions’. This is a separate bucket of money from your traditional or Roth 401k contributions and if allowed by your 401k plan allows you to put up to another $38,500 into your 401k ‘after-tax’ once you have maxed your original $19,500/$26,000 in 2021.
- In-Service Withdrawals or Conversions – The next requirement is that your 401k plan allows either for in-service withdrawals (be careful, many plans allow for these withdrawals, but have age restrictions) or conversions.
- An in-service withdrawal would allow you to move the after-tax contributions from step 1 into an IRA, then convert some same dollars to a Roth IRA.
- The conversion would keep those retirement dollars inside of your 401k, but instead of after-tax, they would sit in the Roth 401k bucket, allowing contributions and earnings on those contributions to grow tax free.
- Savings Capability – A mega backdoor Roth IRA requires an individual to save anywhere from $19,501 – $58,000 (under 50 years old) in 2021 into retirement accounts. If you’re currently not able to save more than $19,500 as an individual, then attempting a mega backdoor Roth could likely be a goal for you in future years. (For now, we have some helpful savings reminders at the bottom of this article)
With these 3 hurdles out of the way, you now are in a position to save up to $58,000 per year into a Roth 401k/Roth IRA!
What Are the Benefits of Doing This?
Great question! Roth IRAs help individuals and couples in many unique ways for tax & estate planning later in life.
- First and foremost, a Roth IRA allows you tax-free income in retirement. This can be an effective tool when managing income needs for expenses in retirement, while also keeping in mind tripping into new tax brackets and Medicare Income-Related Monthly Adjustment Amounts.
- No Required Minimum Distributions! We consistently see clients that have ‘saved too well’. It doesn’t sound like an issue, but it can be from a tax perspective. Many individuals and couples could benefit from Roth IRA assets rather than Traditional IRA contributions to minimize future RMDs in retirement.
- Your kids will thank you. If you plan to pass assets down to the next generation, inheriting tax-free dollars from a Roth IRA clearly is a tax advantageous gift!
- Lower restrictions & penalties if you need the money before retirement. Pulling funds from a traditional IRA before 59 ½ triggers an income tax bill + 10% early withdrawal penalty. But if you had a Roth IRA, you have the opportunity to avoid both the taxes and penalty as long as you are withdrawing original contributions, not earnings.
This All Seems a Bit Complicated
That’s because it is! Mega Backdoor Roth 401k/IRAs are complex as are the rules related to these retirement planning strategies. That’s why your team at Innova is here for you. If you think any of this might relate to you or your future retirement planning, do not hesitate to reach out to your advisor at Innova Wealth Partners today!
Can’t Do a Mega Backdoor Roth Right Now? No Problem
FOMO isn’t necessary! There are other ways to begin building your Roth IRA where you’ll never owe taxes on those dollars again:
- You can contribute directly to a Roth IRA.
- If you’re over annual income limits, you can complete a backdoor Roth.
- And most importantly, if your employer offers a Roth 401(k), you can contribute to that.
Innova Wealth Partners, LLC (“Innova”) is a registered investment advisor. Information presented herein is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed.
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The tax information and estate planning information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. Innova does not provide legal or tax advice. Innova cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws that may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax investment results. Innova makes no warranties with regard to such information or results obtained by its use. Innova disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax professional regarding your specific legal or tax situation.