I often talk about diversifying your retirement money’s tax exposure, because I believe investors should have retirement funds that vary in tax treatment, including tax-deferred, tax-free and after-tax non-retirement money. This tax diversification can help investors control their tax situation in retirement, preparing them for when they must take required minimum distributions, which are taxed at normal rates.
Unfortunately, high-income earners have few opportunities to save tax-free money. They earn too much to contribute to a Roth IRA. Traditional IRAs are often non-deductible, and 401(k) plans are generally tax-deferred savings. High-income earners usually take advantage of backdoor Roth IRA contributions—making a non-deductible IRA contribution and then converting the funds to a Roth account, but this is limited to $6,000 a year, or $7,000 for those 50 and older. If high-income earners have access to a Roth 401(k) at work, they may be able to contribute up to $19,500 ($26,000 for 50 and older) to the tax-free portion of their company-sponsored retirement plan.
However, there is a little-known strategy—the mega backdoor Roth IRA—that allows investors to sweep up to $58,000, or up to $64,500 for 50 and older, into a retirement account that grows tax-free. This “loophole” in the Roth conversion rules takes place in your 401(k).
To use this mega backdoor Roth IRA, you need three things:
- A 401(k) plan that allows you to contribute up to the limit with after-tax contributions.
- Your employer offers either in-service distributions to a Roth IRA or lets you move money from the after-tax portion of your plan into the Roth 401(k) portion.
- You must have money left over to save, even after maxing out your regular 401(k) and Roth IRA contributions.
First an investor must contribute $19,500 (or $26,000 for 50 and older) to either their pre-tax 401(k) or Roth 401(k). Then the investor can contribute up to $38,500 more after tax to their plan to reach the contribution limit of $58,000 ($64,500 for 50 and older). Keep in mind that employer contributions to the plan count toward the contribution limit, so if you receive employer matching contributions, those funds will always be pre-tax.
Once the after-tax contributions are made to the plan, the investor can convert the money to a Roth IRA using an in-service withdrawal or convert it to the company’s Roth 401(k) option as soon as possible to minimize any tax-deferred growth on the money. Even if some tax is due on the increase upon the conversion, it should be significantly less than the several years of growth had the money remained in the tax-deferred account. Because this strategy is implemented within a 401(k), the pro-rata rules don’t apply, meaning the investor can choose to convert only the after-tax dollars to the Roth accounts.
There are several of nuances to this investment strategy, so working with a financial adviser and your 401(k) administrator is essential. However, with proper planning, high-income earners may have this unique opportunity to save a significant amount to Roth accounts and benefit from tax-free growth for many years.