Mega Backdoor Roth – How it Works and How it Could Benefit You

Mega Backdoor Roth – How it Works and How it Could Benefit You
Topics InvestingRetirement

When it comes to saving for retirement, many of us are already familiar with the primary investment savings vehicles offered to us, the individual retirement account (IRA) and the employer-sponsored retirement account, such as the 401(k) and 403(b). However, if you are fortunate enough to work for a company that allows it, you may be able to take advantage of what is known as the “mega backdoor” Roth IRA. Utilizing this strategy would allow you to set aside significantly more in retirement savings, up to an additional $38,500 per year. There are also no income limits as there are with ordinary Roth IRAs. And maybe most importantly, with the uncertainty surrounding future tax rates, the savings will grow tax-exempt.

How it works

At present, you may only elect to defer $19,500 of compensation in your 401(k) annually (more if you are over 50). This limit applies to pre-tax contributions, however. The IRS allows for total contributions of $58,000 (and again, more if you are over 50), meaning you can make up the difference in post-tax contributions.

To take advantage of this strategy, your company must 1) allow for after-tax contributions to its 401(k) plan, and 2) distributions out to a Roth IRA or to within a Roth 401(k) while you are still employed. Your workplace human resources or benefits group will be able to answer this question for you. Provided that your company allows for both, first be sure that you have the savings available to make further contributions. Having an emergency fund in place already and paying down high interest debt should take priority.

Your next step is to figure out how much additional you may contribute. Company matches count as well, so add that to what you have contributed already throughout the year. As an example, assume you contributed $19,500 in the year and received a company match of $6,500, for a total of $26,000. The difference is what you may contribute up to the $58,000 limit, in this case $32,000.

Once you have made your additional contribution, recall that while these funds are post-tax, any earnings will not be. Thus, as soon as you are able, you will want to either establish a Roth 401(k) at your company or take a distribution out to a Roth IRA. You may owe some tax on the earnings, but after converting into a Roth vehicle, the money will grow tax-free and without required minimum distributions. Even better, future distributions at retirement will be tax-free as well.

The “mega backdoor” Roth is not for everyone but can be a powerful savings technique for those with additional funds to set aside for retirement. A financial advisor can help you to decide if a Roth strategy is right for you and your overall financial plan, as well as ensuring that it is done correctly.

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