As a continuation of last week’s post on Roth Conversions, today we share insights on Mega Backdoor Roth Strategies. These methods are powerful tools for boosting retirement savings. In this blog post, we'll explore the different types of retirement plan accounts and how to leverage Roth conversions and Mega Backdoor Roth Strategies for their potential tax benefits.

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Understanding Retirement Plan Account Types

Planning for retirement can be complex, but understanding the differences between traditional and Roth accounts is crucial:

Traditional IRA/401(k): Contributions are made pre-tax, reducing taxable income in the year of contribution, but withdrawals during retirement are taxed as ordinary income.

Roth IRA/401(k): Contributions are made with after-tax dollars, but qualified withdrawals of contributions and earnings during retirement are tax-free.

Choosing between these accounts depends on your financial goals and circumstances. When considering a Mega Backdoor Roth strategy, balance the potential benefits of tax-free growth against the immediate tax savings offered by traditional accounts.

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Roth Conversions for Tax-Free Growth

The Roth retirement accounts differ from traditional retirement accounts in 3 main ways:  

1. Qualified distributions of earnings from a Roth retirement account are not included in taxable income.

2. Roth retirement accounts do not have required minimum distributions.

3. Inherited Roth retirement accounts allow heirs to receive tax-free distributions.

Upgrading your retirement plan by converting a traditional IRA/401(k) to a Roth IRA/401(k) can offer significant tax advantages and eliminate required minimum distributions (RMDs). In last week’s blog, we highlighted how to convert to a Roth and the numerous benefits. Roth conversions are a great estate planning tool, as inherited Roth IRAs have more favorable distribution rules, allow an individual to diversify tax exposure, and provide flexibility in retirement.

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Now to The Mega Backdoor Roth Strategy

Another method to accumulate post-tax retirement funds in a Roth 401(k)/IRA is via the Mega Backdoor Roth.  This strategy allows you to significantly increase your retirement savings by utilizing after-tax contributions and in-service withdrawals or conversions.

Here’s how the Mega Backdoor Roth strategy works. First, this strategy requires that you are part of an employer-sponsored retirement plan that allows for after-tax contributions.  These are contributions made to your company-sponsored retirement plan with after-tax dollars. If these contributions are left within the employer-sponsored plan they grow tax-deferred, but the earnings on those contributions are still taxable upon withdrawal or conversion.

For the Mega Backdoor Roth, the next step is the In-Service Withdrawal or Conversion.  Again, the employer-sponsored plan must allow for in-service withdrawals or conversions, so be sure to check with your plan sponsor. Once you have made the after-tax contributions and performed the in-service withdrawal or conversion to a Roth 401(k) or IRA, you will be left with a funded Roth retirement account.

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Contribution Limits

We must be mindful of the annual total contribution limits to retirement accounts.  For 2024, an employee under age 50 can contribute up to a total of $23,000 to the employer-sponsored 401(k) or Roth 401(k).   That same employee also has an annual aggregate limit for all retirement contributions of $69,000.  This aggregate limit includes employee pre-tax 401(k) and Roth 401(k) contributions, employer contributions, and after-tax contributions.  So, the difference between the employee contribution limit of $23,000 and the aggregate limit of $69,000 can be filled with employer contributions or the after-tax contributions that may be used for the Mega Backdoor Roth.

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Planning opportunity:   Be mindful of the aggregate retirement contribution limit of $69,000.  Be sure to leave enough space for your employer’s matching contribution if it is offered.  If you fully fund your retirement account with after-tax contributions, you may be forfeiting your employer’s match.

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Example of Mega Backdoor Roth Strategy with a Company Match

Let’s explore how the Mega Backdoor Roth strategy can work for you. Assume you earn $100,000, are under age 50, and your employer matches 50% of your retirement contributions up to 6% of your salary.  In this case, the employer match contribution maximum is $3,000 leaving you $66,000 of overall retirement contribution limit, including after-tax contributions.

A Mega Backdoor Roth strategy may include the following:

1. Contribute $23,000 of pre-tax income to the employer-sponsored 401(k)

2. Receive $3,000 matching contribution from employer into your 401(k).

3. Make after-tax contributions up to the annual aggregate limit, which in this case would be $43,000.

4. Convert the after-tax contributions of $43,000 into a Roth IRA through an in-service withdrawal or conversion.

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Planning Opportunity:  Planning ahead is crucial for executing a Mega Backdoor Roth Strategy. Be sure to consider how much you are saving in retirement accounts vs taxable accounts.  While contributing to retirement accounts is typically recommended, you want to ensure you have liquidity available outside of your retirement accounts to avoid unnecessary taxes and penalties on early withdrawals.

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Seek Mega Backdoor Roth Strategy Planning with GatePass Capital

Mega Backdoor Roth strategies may be a great way to maximize your retirement savings and minimize your overall tax burden.  For personalized advice and guidance, seek assistance from experienced advisors, who have the tools and knowledge to guide you effectively. Schedule a call with a member of our team today.

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