The Backdoor Roth IRA & The Mega Backdoor Roth
For those whose income is too high to contribute directly to a Roth IRA, there’s a back door. The Backdoor Roth IRA is a sort of tax-advantaged loophole that’s been open for over a decade now. You should consider this strategy if you’re looking to get more dollars into a Roth vehicle.
What is a Backdoor Roth IRA?
In our post about IRAs, we pointed out that even though they come with significant tax advantages, Roth IRAs have limitations on who can contribute to them based on income.
The point of view is that high-income folks do not need additional advantages in saving for retirement.
Well, as it turns out, in 2010 congress left a loophole in tax legislation that still allows individuals of all incomes to contribute indirectly to a Roth IRA.
They left a back door open.
How does it work?
By contributing to a Traditional IRA on an after-tax basis, then converting the contributions to a Roth IRA, high-income savers can avoid the income restrictions designed to prevent them from participating in a Roth IRA.
For illustration purposes, let’s consider Backdoor Ben as an example of how this works.
Ben is single and has an annual income of $165,000 per year in 2023. This makes him ineligible to contribute directly to a Roth IRA.
Being an astute reader of all things personal finance, Ben stumbles upon Martin Money one day and learns about the Backdoor Roth IRA.
Immediately, Ben jumps on his investment banker’s website and contributes $6,500 (the contribution limit for 2023) into a Traditional IRA (forgoing the tax deduction) and leaves the balance in cash so it doesn’t grow and trigger any tax issues when he completes the next step.
After a few days, weeks, or months (how long is a matter of some debate) Ben logs in again and converts the $6,500 balance to a Roth IRA.
Ben must pay income tax on his conversion, but he has now effectively made a $6,500 contribution to a Roth IRA in a year in which his income should have disqualified him.
Pretty slick, huh?
The Pro Rata Rule
If there’s a “not so fast” to this plan, the pro rata rule is it.
Basically, the pro rata rule is an IRS statute that requires taxpayers to consider the entirety of all Traditional IRA assets when calculating taxes for a conversion.
“Pro rata” or “proportionally” means if Ben has any other Traditional IRA balances which exist as the result of tax-deferred contributions (which is how nearly everyone uses a Traditional IRA), then he must lump them in with his after-tax portion to calculate his tax liability.
For example, let’s assume Backdoor Ben has a traditional IRA worth $20,000 that’s several years old. Ben wants to put $5,000 in a Roth IRA.
Since in the eyes of the IRS, Ben had a $25,000 Traditional balance, he will have to pay income tax on 80% ($20k untaxed/$25k total) of the converted amount. In this case, $4,000 of the conversion is subject to income tax.
The pro rata rule applies to all Traditional IRA accounts, no matter how young or old, even if they’re with different custodians. If it’s in your name, it’s all one Traditional IRA account to Uncle Sam.
If you don’t have a very large Traditional IRA balance, you might move forward with this plan anyway or you could just focus on converting the existing accounts before bothering with the backdoor Roth method.
However, if you have a large 401(k) balance from an old employer that was rolled into a Traditional IRA after moving jobs (like I do), then it may be quite expensive tax-wise to go this route.
The Mega Backdoor Roth
After-tax contributions to a Traditional IRA are still limited to a maximum of $6,500 in 2023 ($7,500 if you’re 50 or older). This means the normal backdoor is only open wide enough for this maximum contribution amount each tax year.
Well, as it turns out there’s yet another loophole, and this one has a much, much larger door.
In 2023, although you can only contribute $6,500 to a Traditional IRA, employees can contribute up to $22,500 ($30,000 if you’re 50 or older) to a 401(k) on a tax-deferred basis.
Furthermore, employees can contribute up to $66,000 ($73,500 if 50 or older) to a 401(k) on an after-tax basis, assuming their employer’s plan allows them to do so.
If an employer-sponsored plan also allows for transfers of these after-tax deposits into a Roth 401(k), these account holders can contribute up to this full after-tax amount each tax year, then transfer the balance into a Roth 401(k) and enjoy tax-free growth from then on.
And, if the employer plan allows, these Mega Rothers can then roll the balance over to a Roth IRA if they so desire.
In other words, this backdoor Roth method could allow an individual to deposit up to $73,000 into a Roth IRA in a single tax year!!!
I realize that you need to have strong income to maximize this route, but even if you could only put a portion of this amount into a Roth, it provides an enormous opportunity.
Again, you would be forgoing the present-day tax deduction for any amounts you decide to contribute on an after-tax basis and you would owe income tax on any amounts that hadn’t previously been taxed.
You also have the option to put the maximum tax-deferred amount into the account, keep contributing after-tax dollars, then roll over any portion of your contribution to the Roth.
Mega Backdoor Ben
Let’s look back at Backdoor Ben for an example of how this works.
Ben is now 55 and is really making hay at the company he works for. His salary and expenses are positioned in such a way that Ben can afford to divert $73,000 into his 401(k) each year.
So, Ben adjusts his monthly 401(k) withholding to reach the maximum contribution amount for the year.
Ben is also in a relatively low tax bracket, despite being able to divert so much money to savings so he decides to make all contributions on an after-tax basis to maximize the amount going into the Roth 401(k).
After some time (whatever Ben is comfortable with) he transfers the after-tax portions of his 401(k) to the Roth 401(k) where the investments grow tax-free forever.
If Ben so desires, he can also roll over the Roth 401(k) to a Roth IRA or wait until retirement to do so.
A Few Things to Keep in Mind…
- Directing so much money into a 401(k) may exhaust your employer’s ability to make matching contributions early in the year. They cannot contribute matching funds once the account balance reaches the annual max, so plan this carefully.
- If your employer 401(k) plan allows, you can also roll over 401(k) assets into a Traditional IRA and then convert to a Roth IRA. This is a little more complicated than maxing out your employer’s Roth 401(k), but it is a route you can take. Just keep in mind that any contributions that haven’t been taxed yet will be subject to income tax when the conversion is made.
- Every 401(k) plan is different. Make sure you understand the limitations of your own plan before attempting the Mega Backdoor Roth approach.
