Roth mega backdoor is a unique 401(k) rollover strategy designed for people who normally keep their income from saving in an Individual Roth Retirement Account. The benefit of using a Roth IRA to save for retirement is being able to make tax-free qualified withdrawals. But not everyone can contribute to these accounts; high income earners are excluded. That’s where the mega backdoor Roth comes into play. If you have a 401(k) that you’d like to roll over, you could use this strategy to enjoy the tax advantages of a Roth IRA without being a barrier to income.
Make sure you’re taking advantage of every opportunity to maximize your retirement assets by working with a financial advisor.
Roth Account Basics
Before diving into the mega backdoor Roth specifics, there are a few things to know about Roth accounts, including Roth IRAs and Roth 401(k)s.
First, these accounts are funded with after-tax dollars. That means when you make qualified withdrawals later, you won’t pay income tax on the money since you paid it up front. This is the main characteristic of Roth accounts and what makes them so attractive to investors who hope to be in a higher tax bracket at retirement.
Then, your ability to contribute to a Roth 401(k) is not restricted by your income. But it belongs to a Roth IRA. For the 2021 tax year, you must be within these revised gross income limits to make a full Roth IRA contribution:
Single filers: MAGI of $125,000 or less
Married filing jointly: MAGI of $198,000 or less
Head of household: MAGI of $125,000 or less
You can make partial contributions above these income limits. But your ability to contribute stops completely once your MAGI hits $140,000 (if you file single or head of household) or $208,000 if you’re married and file a joint return. For 2021, the total contribution allowed is $6,000 with a follow-on contribution of $1,000 for savers aged 50 and over.
Finally, Roth 401(k) accounts are subject to minimum distribution rules, just like a traditional 401(k) account. This rule requires you to start taking money from your 401(k) starting at age 72. A Roth IRA, on the other hand, is not subject to RMD rules.
What is a Backdoor Wheel?
Roth backdoor offers a work around for people whose income is above the limits set by the IRS. When you execute a backdoor Roth, you roll money from a traditional IRA into a Roth account. This way, you won’t have to pay taxes on your retirement savings in the Roth IRA when it’s time to make withdrawals. And you’re not subject to the minimum distribution rules either.
But there is a catch. You have to pay income tax on the money rolled over to a Roth account. So, while you may save money on taxes in retirement, you’re not completely escaping the tax liability of a traditional IRA.
How the Mega Backdoor Wheel Works
A mega backdoor Roth is a backdoor Roth specifically designed for people with a 401(k) plan at work. This type of Roth backdoor allows you to contribute up to $38,500 to a Roth IRA or Roth 401(k) in 2021. This is in addition to the regular annual contribution limits allowed by the IRS for these types of accounts. To run a mega backdoor Wheel, two conditions must be met. Your 401(k) plan must allow for the following:
You can ask your plan administrator if your 401(k) meets these criteria. And if your plan doesn’t allow in-service withdrawals or distributions, you could try a mega backdoor Roth if you plan to leave your job in the near future.
If your plan meets the criteria, then you can take the next steps to execute a mega backdoor Wheel. This is usually a two-step process of maxing out after-tax 401(k) contributions, and then withdrawing the after-tax portion of your account to a Roth IRA.
Again, whether you can continue with the second step depends on whether your plan allows in-service withdrawals. If it doesn’t, you’ll have to wait until you separate from your employer to roll any after-tax money in your 401(k) into a Roth IRA.
You also need to watch out for the pro rata rule. This IRS rule states that you can only withdraw pre-tax or after-tax contributions from a traditional 401(k). So if you’re completing a mega backdoor Roth, you wouldn’t be able to withdraw after-tax contributions right away if you have both pre-tax and after-tax funds in your account. In that case, you may need to roll over the entire balance to a Roth IRA.
Advantages of Wheel Mega Backdoor
There are three main advantages to executing a Roth mega backdoor. First, you can contribute significantly to an upfront Roth IRA this way. For 2021, the contribution limit is $38,500 in addition to the normal annual contribution limit and any additional contribution limits that may apply.
You will know the maximum amount you are allowed to contribute to the after-tax portion of your 401(k). So for 2021, the IRS allows a maximum contribution of $58,000 or $64,500 if you are 50 or older. You would add your 401(k) contributions and anything your employer adds as matching contributions to figure out how much you could add to the after-tax portion.
Then, you can enjoy tax-free withdrawals in retirement. This is a benefit that you cannot otherwise receive if your income is too high to contribute to a Roth IRA. By reducing your tax liability in retirement, you can help your investment dollars go further. And you may have a greater legacy of wealth to pass on to future generations.
Finally, a backdoor mega Roth IRA would allow you to bypass the required minimum distribution rules. This means you could retain control over when you choose to take distributions from a Roth IRA.
So who is a mega backdoor wheel right? You may consider this move if:
Have an eligible 401(k) plan at work
Have you maxed out traditional 401(k) contributions
They are not eligible to contribute to a Roth IRA because of your income
Have extra money that you want to invest for retirement
Trying to leverage the higher Roth IRA contribution limits allowed with a mega backdoor rollover
Talking to your financial advisor can help you decide if a mega backdoor Roth makes sense. And your 401(k) plan administrator should be able to tell you if it’s possible, based on your plan’s guidelines.
Mega Backdoor Wheel Alternatives
If you can’t execute a mega backdoor Roth because your plan doesn’t allow it, there are other ways to increase your retirement savings. For example, you could try a regular backdoor Wheel instead. This may be something to consider if you still want to enjoy the tax benefits of a Roth IRA but your plan doesn’t meet the criteria for a mega rollover. You could also choose to make Roth 401(k) contributions to your retirement plan at work. This way, you still get the benefit of contributing after-tax dollars and making tax-free withdrawals. You would be subject to the regular contribution limits and would still be required to take the required minimum distribution. But that could be more important than the value of the tax savings in retirement.
Another option is to invest in a Health Savings Account (HSA). Although these accounts are not specifically designed for retirement, they can provide multiple tax benefits. Contributions are tax deductible and grow tax deferred. Withdrawals are tax-free when used for eligible health care expenses. And at 65, you can withdraw money from an HSA for any reason without tax penalty. You will only pay ordinary income tax on any withdrawals not used for health care expenses.
Finally, you could open a taxable brokerage account to invest. This does not necessarily save you money on taxes as you will owe capital gains tax when you sell investments at a profit. But it can help you diversify your investments and there are no limits on how much you can invest in a brokerage account each year.
Roth’s mega backdoor strategy may work well for higher income earners who want to take advantage of the benefits of a Roth account. There are certain rules that must be followed for it to work, however, so you may want to talk to your plan administrator or a tax professional before proceeding. Also keep in mind that even if you are unable to complete a mega backdoor Roth rollover, you still have other options to increase retirement savings.
Tips for Retirement Planning
If you’re saving for retirement in a 401(k) or IRA, pay attention to the fees you’re paying. For example, check the expense ratios for each fund you are invested in to understand how much you pay to own that fund on an annual basis. You can compare that to the fund’s performance to determine whether the fees are justified. Also, consider any administration fees you may be paying and how these affect your net returns.
Consider talking to your financial advisor about a mega backdoor Roth and whether it might be right for you. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s financial adviser matching tool makes it easy to connect with professional advisers in your local area. You can get your personalized recommendations in minutes by answering a few simple questions. If you’re ready, start now.
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