Backdoor Roth IRAs Are an Easy Retirement Hack

Backdoor introduction

We’ve written several times about Roth IRAs, including how they compare to Traditional accounts and the popular Roth IRA conversion hack. In this additional installment of our Roth IRA series we’ll look at one more retirement savings hack called a “backdoor Roth IRA” and it’s bigger sibling the “mega backdoor Roth IRA.”

Both are easy and effective techniques that can help individuals save large amounts into Roth IRAs, even if they are above the income limits for direct contributions.

How does a backdoor Roth IRA work?

If your income disqualifies you from contributing into a Roth IRA account, you might have considered a Roth IRA conversion. But that only works if you have Traditional retirement account assets that you can and want to convert. If you don’t, then you could consider a backdoor Roth IRA instead.

A backdoor Roth IRA is a two step process that begins by making a non-deductible Traditional IRA contribution, and ends by performing the aforementioned Roth IRA conversion. Here’s how it works.

1. Open a Traditional IRA: If you don’t already have a traditional IRA, start by opening one with a reputable financial institution.
2. Make a Non-Deductible Contribution: Contribute funds to your traditional IRA, but make sure these contributions are designated as non-deductible. You won’t get a tax deduction for these contributions.
3. Convert to a Roth IRA: After making the non-deductible contribution, convert the money to a Roth IRA. You’ll need to pay taxes on any earnings made between contribution and conversion.
4. Tax Implications: Since you’ve already paid taxes on the non-deductible contributions, you won’t incur taxes on the principal when you convert to a Roth IRA. This is where the “backdoor” comes in – you’ve effectively snuck your money into a Roth account.
5. Benefits: Once your money is in the Roth IRA, you enjoy the tax benefits including tax-deferred growth and tax-free treatment of qualified withdrawals.

Meet mega backdoor Roth

One issue with a standard backdoor Roth strategy is contributions are subject to annual limits, $6,500 as of 2023 (or$7,500 for 50+). At $6,500 a year, it would take a long time to amass a substantial amount into a Roth IRA.

This is where the mega backdoor Roth IRA comes in. It’s a strategy that enables you to contribute larger amounts into a Roth IRA beyond the standard limits. However, it does require participation in a sponsored retirement plan like a 401(k) plan that allows for it. Here’s how it works.

1. Check with Your Employer: Not all 401(k) plans allow for mega backdoor Roth contributions, so check with your employer or plan administrator to see if it’s an option.
2. Max Out Your 401(k): Ensure you’ve maximized your employee contributions to your employer-sponsored 401(k). For 2023, the annual limit is $22,500 (or $30k for 50+). In some cases you may be able to allocate between Traditional and/or Roth 401(k) components.
3. After-Tax Contributions: If your plan permits, contribute additional after-tax funds to your 401(k) beyond the standard limit. In 2023, the total annual IRS contribution limit, including both pre-tax and after-tax contributions, is $66,000. In other words, after maxing your standard $22.5k contribution, and after any employer matching, you could potentially make extra contributions up to $66k (after taxes).
4. In-Service Distributions: Some plans allow you to distribute funds from your 401(k) plan account while you’re still employed, which is called an “in-service distribution.” You could use this to distribute your after-tax contributions.
5. Rollover to Roth IRA: Request an in-service distribution of your after-tax contributions, and then promptly roll those funds over to a Roth IRA. Earnings on the after-tax portion may be subject to taxation. In some cases, it could be possible to do a direct rollover, where the distribution and rollover are combined into one step.
6. Benefits: The mega backdoor Roth allows you to contribute significantly more money to a Roth IRA each year, potentially turbocharging your retirement savings. Assuming you could allocate your standard contributions to the Roth 401(k) component, that means you could potentially backdoor $66k per year into a Roth.

Considerations and summary

Backdoor and mega backdoor Roth strategies are easy retirement hacks that can help individuals save into Roth IRA accounts, even if they are above the income limits for direct Roth IRA contributions.

However, in addition to the benefits of Roth IRAs, there are several considerations to keep in mind about these hacks including the following.

If you have balances in existing pre-tax retirement accounts like Traditional IRAs, you may be subject to special pro-rata tax and accounting rules when performing a Roth conversion.

That means the ratio of your pre-tax vs Roth conversion balances may effect the amount of taxes due. Afterward, you will need to keep track of what balances have been taxed.

For mega backdoor Roth IRAs, you must participate in an employer sponsored retirement plan (like a 401(k) or similar) that allows for the mega backdoor techniques. This includes after-tax contributions, maximum IRS limits, and in-service distributions.

Whether backdoor or mega, you may need to properly report your transactions when filing your taxes to avoid tax consequences.

There may be additional considerations as well, depending on your circumstances. That brings us to our final point, in any case you should have a clear understanding of your financial circumstances to ensure your actions are best for your needs and goals.

If you don’t know how to do that, have questions or need help, then don’t hesitate to consult with qualified tax and financial advisor.*

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HWL

*Nothing in this post represents tax or financial advice. You should consult with professional tax and financial advisors for personal advice.