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Backdoor Approach to Roth IRA Contributions

Backdoor Approach to Roth IRA Contributions

November 17, 2021

Backdoor Roth and Mega Backdoor Roth Strategies to Maximize Tax Free Potential 

You may be familiar with the many benefits of Roth IRAs.  Unlike ordinary IRAs or 401ks, Roths are funded with money that has already been taxed, so there is no immediate benefit of a tax deduction as there is with “pre-tax” IRA or 401k contributions.  However, once funds are invested in a Roth, they can essentially grow tax free for the rest of your life.  Unlike your pre tax investments, you will NEVER be taxed on either what you put in, or the growth – even in retirement.  Even if your kids inherit your Roth money – it is still tax free to them! 

The problem with Roths however is that you can only contribute $6500 per year – and that only if your income is low enough to be eligible.  Over enough years you can build up a meaningful balance, but it takes time. 

There are loopholes in the rules however, which can permit some people to amass sizable Roth accounts, or to contribute to Roths even if their income is too high.  Both of the loopholes are based on the fact that the law allows you to convert IRA or 401k money to a Roth – without limitation – as long as you pay any tax due on the funds being converted. 

Enter the “Backdoor Roth” and “Mega Backdoor Roth” contribution.

The backdoor Roth has you contribute your regular $6500 annual contribution to an After Tax IRA account.  Shortly thereafter, you convert the traditional IRA to a Roth.  Tax is due on any interest, dividends, or increase in value – but not on the after tax contribution itself.  You can do this year after year and build a substantial tax free nest egg over time. 

A related strategy, with potentially much bigger impact, is the Mega Backdoor Roth.  Instead of making an after tax contribution to an IRA, you make the maximum allowed after tax contribution to your employer 401k.  Not well known or often advertised, many plans allow participants to make after tax contributions well in excess of the regular employee contributions. 

For instance, an employee may make contributions from payroll of up to $19,500 per year, $25,500 if you are over 50.  Then the employer can make matching payments, or may even (if your employer is most generous) top it off with additional profit sharing contributions.  The law does stipulate that for 2021 the maximum amount FROM ALL SOURCES that can be stashed in an employer 401k account is $58,000, or $64,500 if you are over 50.  

What is unknown to many is that many employer plans are setup to permit employees to make AFTER TAX contributions to top off this larger limit.  For instance, let’s say you are over 50 and contributed through payroll deductions the max of $25,500.  You employer matched $10,000, so your total contribution for the year was $35,500.  If your plan allows AFTER TAX contributions, you can then put in ANOTHER $29,000 of after tax money. 

Why would you do that?  Well, that’s where the fun begins.

After making your maximum allowable after tax contribution, you can request an IN SERVICE DISTRIBUTION in the form of a rollover OF ONLY YOUR AFTER TAX FUNDS to a Roth IRA.  Bingo, you have sidestepped a) the maximum income limitation on Roth Contributions AND the $6500 cap on annual contributions.  If you and a spouse both have employer plans that have these features, the annual contribution can be quite substantial. 

So how do you know if you can do this?

Check with your plan administrator and find out the following: 

Do they allow after tax contributions to the plan up to the Section 415 limit ($58k / 64.5k)?

Do they allow partial in service rollovers of after tax funds? 

If the answer to both is yes, and if you have sufficient after tax funds that you can stash away in retirement savings, this may be an opportunity you can’t pass up.  If you can verify that your plan has access to these features and want to discuss with me personally, just schedule a phone call or zoom meeting on my calendar   

There is one caveat…Congress is discussing elimination of this provision in the law, so this may be the last year you will be able to take advantage of this strate