Mega Backdoor Roth IRA – Is It Right For Me?

Mega Backdoor Roth IRA – Is It Right For Me?

February 02, 2021
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A Roth IRA is a fantastic way to save for the future because:

  • It allows for tax-free income during your retirement
  • You are also able to access your principal contributions without penalty or taxes if the account has been opened for more than 5 years
  • There are no required minimum distributions in your lifetime
  • Can be an excellent estate planning tool

However, there are some limitations to how much you can save and who can use this account. The annual contribution limit for 2021 in a Roth IRA is $6,000 (there is a limit of $7,000 if you are over 50). Also, high-income individuals are prohibited from making contributions. In 2021, if you earn more than $140,000 (filing as Single or Head of Household) or $208,000 (Married Filing Jointly), you may not contribute to a Roth IRA… directly.

There is a way around this: a backdoor Roth IRA, also known as a Roth conversion. Those with earned income that is over the threshold may instead first make a nondeductible contribution to a traditional IRA, and then convert it to a Roth IRA. This is a non taxable event as long as there are no gains in the account.  It is an excellent strategy to build a tax-free income stream in retirement.

Now, if you really want to supercharge your Roth savings and have the cash flow to do so, a Mega Backdoor Roth IRA might be a right fit for you. With this method, you can sock away up to $38,500 per year into a Roth IRA. Below is an example if you utilized this strategy for 10 years starting at age 40 and assuming a growth rate of 7%. By saving $385,000 over ten years, it would be worth well over $1 million tax-free in retirement.

To start, you need to ensure the following for the retirement accounts that you have:

  • Max pre-tax contributions to 401(k), 403(b), or 457 account.
  • Max nondeductible traditional IRA contributions.
  • Max after-tax contributions to a 401(k) that is over the annual limit ($19,500 for 2021)
    • Your employer’s retirement plan must allow for in-service withdrawals of these after-tax contributions. Check with your plan if this is available.

Your 401(k) contribution limits are what limit what you may put into a mega backdoor Roth IRA. To calculate this, the total contribution limit (pre-tax, after-tax, employer matching, employer contribution) of $58,000 ($64,500 for those over age 50) is subtracted by both the pre-tax contribution limit of $19,500 ($26,000 for those over age 50) and the employer matching contributions made. If there is no employer matching, the maximum mega backdoor Roth IRA contribution for 2021 is $38,500.

By utilizing the after-tax contributions and in-service conversion within your 401(k) plan, you have the ability stash more than usual into a Roth IRA for tax-free growth, as long as you wait until age 59 ½ to take withdrawals.

If you meet these income and savings requirements, a mega backdoor Roth IRA may be right for you. You will receive both tax-free income along with the tax-deferred income from your other accounts, which results in a diversified income stream for your retirement.