Exploring the Mega Backdoor Roth IRA Strategy

Does your 401(k) offer an after-tax component? If so, you might be eligible to take advantage of the “Mega Backdoor Roth IRA strategy.” At Seaside Wealth Management, we’re here to help you navigate this powerful strategy and make the most of your retirement savings.

The Appeal of Roth IRAs

For many people, contributing to a Roth IRA is a fantastic way to save for retirement due to its tax advantages. As long as you are over the age of 59.5 and have had the Roth IRA for at least 5 years, all your distributions in retirement are tax-free. Given the current economic climate, many experts anticipate that tax rates will rise in the near term. Even if no new tax laws are enacted, the Tax Cuts and Jobs Act will sunset after 2025, resulting in higher tax rates. Coupled with the recent federal spending due to the pandemic and increased government debt the likelihood of increased future taxes makes a Roth IRA even more valuable. Be sure to watch our Retirement Master Class, where Brad expertly covers everything you need to know about Roth conversions in retirement.

Challenges for High-Income Earners

The challenge for many high-income earners is that they are not eligible to contribute directly to a Roth IRA because their income is too high. For 2024, a married couple with a Modified Adjusted Gross Income above $240,000 is not eligible to contribute to a Roth IRA. For single tax filers the MAGI number is $161,000. Many 401(k) plans offer a Roth component, but high-income earners often prefer to make pre-tax contributions to reduce their tax liability.

The Traditional Backdoor Roth IRA

We have discussed the Backdoor Roth IRA strategy, which remains a valuable option for those who earn too much to contribute directly to a Roth IRA. This involves making a nondeductible contribution to a traditional IRA and then converting it to a Roth IRA. However, there's another strategy that's gaining popularity: the Mega Backdoor Roth IRA.

The Mega Backdoor Roth IRA Strategy

The Mega Backdoor Roth IRA strategy leverages the after-tax contribution option in your 401(k) plan, allowing you to contribute significantly more to a Roth IRA. Here’s how it works in detail:

After-Tax Contributions: Your 401(k) plan must offer an after-tax contribution option. These contributions are separate from your traditional and Roth 401(k) contributions.
Making Contributions: You make contributions to the after-tax component of your 401(k). Note that these contributions do not provide an immediate tax benefit, but they set the stage for future tax-free growth.
In-Service Rollovers: Many 401(k) plans allow for immediate or “in-service” rollovers to your Roth IRA. If your plan allows this, you can roll the after-tax contributions over to your Roth IRA right away. This enables all future growth in the Roth component to be tax-free.
Deferred Rollovers: If your plan does not allow for in-service rollovers, you can still invest the after-tax contributions similarly to your pre-tax or Roth 401(k) contributions. When you change jobs or retire, you can roll the after-tax contributions into a Roth IRA and the growth into a Traditional IRA. This method avoids immediate taxes on the growth while ensuring the contributions remain tax-free.

2024 Contribution Limits

For 2024, the IRS allows a 401(k) plan participant to contribute up to $23,000 if you are under the age of 50, and up to $30,500 if you are 50 or older. The total amount that can be contributed to a 401(k) each year is $69,000 (plus an additional $7,500 if you are over 50). This total includes all contributions—salary deferrals, profit sharing, matching, designated Roth, and after-tax. Exceeding the annual limit typically results in a refund of contributions, so it’s important to consult with your tax professional or financial advisor to fully understand the contribution limits and maximize your benefits.

Potential Pitfalls

While the Mega Backdoor Roth IRA strategy can be highly beneficial, there are some potential pitfalls to be aware of:

Early Withdrawals: If you take a distribution from your after-tax 401(k) before reaching 59.5, you will incur a 10% penalty. The solution is to roll the after-tax contributions to your Roth IRA to avoid this penalty.
Plan Restrictions: Some 401(k) plans only allow for in-service rollovers after reaching a certain age, such as 55 or 59.5. It's crucial to familiarize yourself with your 401(k) plan’s rules to understand what options are available to you.
Complexity: Managing after-tax contributions and rollovers can be complex. Working with a knowledgeable financial advisor can help you navigate these complexities and avoid costly mistakes.

The Benefits of the Mega Backdoor Roth IRA Strategy

The Mega Backdoor Roth IRA strategy allows you to contribute significantly more to your Roth IRA, providing substantial tax-free growth potential. This strategy is particularly advantageous for high-income earners who are otherwise ineligible to contribute directly to a Roth IRA. By utilizing after-tax contributions and strategic rollovers, you can maximize your retirement savings and enjoy the long-term benefits of tax-free distributions.

Conclusion

At Seaside Wealth Management, we are dedicated to helping you make the most of your retirement savings. The Mega Backdoor Roth IRA strategy is just one of the many tools we can help you leverage to secure a comfortable and financially stable retirement. If you would like to learn more about this strategy and how it can benefit you, please feel free to contact our office. We are here to guide you every step of the way, ensuring your financial plan is robust, flexible, and tailored to your unique needs and goals.

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This commentary reflects the personal opinions, viewpoints and analyses of the Seaside Wealth Management, Inc. employees providing such comments, and should not be regarded as a description of advisory services provided by Seaside Wealth Management, Inc. or performance returns of any Seaside Wealth Management, Inc. client. The views reflected in the commentary are subject to change at any time without notice. Nothing in this commentary constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Seaside Wealth Management, Inc. manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.