If you’re like many Floridians, you want to have the most tax-efficient financial plan possible, and one of the greatest tools available to investors is a Roth account which allows for tax-free growth and earnings and a more flexible withdrawal strategy. Unfortunately, many well-off Floridians are unable to directly contribute to the Roth due to income limitations. However, that doesn’t mean there aren’t ways of indirectly contributing to a Roth account.
In this article, we’ll guide you through the steps of executing an intricate financial strategy known as the Mega Backdoor Roth that allows high-income investors to contribute to a Roth IRA. However, considering the nuances and complexities involving a Mega Backdoor Roth, we highly advise reaching out to a fiduciary financial advisor in Sarasota before taking any concrete steps.
Okay, maybe it’s not quite that simple, and that’s why we’re writing this article. Plus, if you were already well aware of the process and implications of a Roth conversion, Secure 2.0 brought about some changes you may be unaware of that may significantly affect your financial strategy.
What is a Mega Backdoor Roth?
The Mega Backdoor Roth is less of a special account and more of a strategy to fund a Roth account. Usually, you cannot contribute to a Roth IRA if your annual income exceeds a certain threshold. In 2023, those figures are $153,000 for single filers and $228,000 for those married and filing jointly. A Mega Backdoor Roth allows a high-earner to contribute to a Roth even if they earn more than the limits imposed by the IRS in some cases.
For high-net-worth individuals in Sarasota and beyond, this strategy can be particularly useful. Not only does it bypass traditional income and contribution restrictions, but it aligns well with broader estate planning objectives as Roth accounts can be passed down as tax-free to beneficiaries as you’ve already paid taxes on the funds within.
The Mega Backdoor Roth Process
Here’s a basic rundown of the actual steps involved in executing a Mega Backdoor Roth. Be sure to read to the end of the article, however, as there are a number of important nuances and restrictions.
Matching Contributions
If you have a 401(K) with a matching program, you’re in an excellent position to boost your retirement savings. And now, companies have the option to designate their matches as Roth.
Pre-Tax Contributions
Start by making the maximum pre-tax contribution to your 401(K) for the year. In 2023, this limit is set at $22,500 across all accounts or $30,000 for those 50 years old and above.
After-Tax Contributions
Once you’ve reached the pre-tax contribution limit, you are then able to make additional after-tax contributions. For 2023, the overall contribution limit, encompassing your contributions, employer contributions, and after-tax contributions, is $66,000, or $73,500 for those 50 and over.
Roth Conversion
The next and final step is the key to the strategy—roll these after-tax contributions over into a Roth IRA or Roth 401(K), depending on what your plan allows.
Now those funds are officially Roth, with all of the rules, regulations, and benefits that entail Roth funds. To qualify for tax and penalty-free withdrawals, you’ll have to wait until you turn 59 ½ to remove earnings, but only after you’ve waited five years after the conversion. If you convert funds well before age 59 ½, you can remove your contributions after five years without fear of penalty and without a tax burden.
Caveats and Considerations
Just because you are a high earner and can afford to contribute a significant amount into your 401(K) to execute a Mega Backdoor Roth, it doesn’t mean you can, as there are still rules that may bar you from doing so. You must also be careful not to end up with a significant tax bill at the end of the year.
Plan Regulations
Before proceeding with this strategy, be sure your plan allows for in-service distributions or conversions to a Roth account. In-service distributions are withdrawals made while still employed. Also, you cannot use hardship withdrawals to execute a Mega Backdoor Roth. The IRS allows you to remove funds from your 401(K) when there is a qualifiable and immediate need, such as a health expense.
Pro Rata Rules
If you have both pre-tax and after-tax money in your 401(K), you’ll have to be cautious. Any conversions or rollovers to a Roth account would involve both pre-tax and after-tax dollars, making them subject to this rule. This means you may inadvertently subject a portion of your conversion to additional taxation.
For example, if your 401(K) has $90,000 in pre-tax contributions and $10,000 in after-tax contributions, and you decide to roll over $10,000 into a Roth IRA or Roth 401(K), the Pro Rata Rule dictates that 90% of that rollover ($9,000) will be considered pre-tax money, and therefore, taxable.
The Pro Rata Rule can complicate your tax situation, so it’s essential to consult a professional to understand how it might impact you.
If You Aren't Eligible
If you are unable to execute a Mega Backdoor Roth conversion due to plan restrictions, you likely aren’t completely ineligible to eventually convert those Traditional 401(K) funds to Roth – you’ll just have to wait until you change jobs, in which case you will be able to roll all of the funds to a Roth account without any restrictions, such as the Pro Rata Rule.
In Conclusion
Executing a Mega Backdoor Roth can be a game-changer for high-net-worth individuals seeking to maximize their retirement savings, especially when contending with income and contribution limitations. However, navigating the complexities of this strategy, such as plan regulations and potential tax implications, requires an in-depth analysis of your financial situation.
That’s where the expertise of a fiduciary financial advisor can prove invaluable. As advisors based in Sarasota, Florida, we specialize in helping high-net-worth families achieve their financial goals by implementing complex strategies like the Mega Backdoor Roth, often in conjunction with estate planning and comprehensive wealth management.
If you’re based in or around Sarasota, Florida, and are serious about optimizing your retirement savings, we invite you to reach out for a personalized consultation by clicking the button below.
