The topic of backdoor and mega backdoor Roths have received recent attention. The attraction to Roth retirement accounts is understandable as contributions grow tax free and future withdrawals are taken tax free. An additional benefit of Roth retirement accounts is that they are not subject to the Required Minimum Distributions of traditional IRA accounts (with the exception of Inherited Roth IRAs, which are not the topic of this article). In this article we explore direct contributions to Roth accounts as well as the concept of backdoor and mega backdoor Roths for higher income earners.
Direct Contribution
If you have a 401k that allows traditional and Roth contributions, you may contribute to your Roth 401k regardless of your income level. For 2021, you may contribute a maximum of $19,500 per year ($26,000 if 50 or older) to your Roth 401k, traditional 401k, or a combination of both.
If you do not have a Roth option in your 401k, you may make a direct contribution to a Roth IRA. However, income limitations prohibit some from contributing directly to a Roth IRA. For the tax year 2021, a single individual must have a modified adjusted gross income of $140,000 or less to be eligible to contribute to a Roth IRA. Those who are married filing jointly must have a household modified adjusted gross income of $208,000 or less to be eligible. The maximum direct contribution phases out for single individuals with modified adjusted gross income of $125,000 or married individuals filing jointly of $198,000. The maximum contribution for 2021 is up to $6,000 ($7,000 if 50 or older).
Backdoor Roth
There are no income limitations on conversion of funds from a traditional IRA to a Roth IRA. Thus, higher income earners may contribute to a Roth IRA by first contributing to a traditional IRA and then rolling over the tax deferred funds into a Roth IRA, known as a backdoor Roth. This Roth IRA conversion typically requires payment of income taxes on funds rolled into the Roth that have not already been taxed. Therefore, it is best to make a non-deductible contribution to a traditional IRA and then do the Roth conversion as soon as possible to minimize taxable gains. Traditional IRAs are subject to the contribution limit of up to $6,000 ($7,000 if 50 or older) for 2021. As discussed below, due to the pro-rata rule, a backdoor Roth works best if you do not have funds in an existing traditional IRA that are pre-tax contributions or deferred gain. If you already have existing funds in a traditional IRA, you may convert up to the entire traditional IRA balance to a Roth subject to payment of tax.
Mega Backdoor Roth
If you still wish to contribute to a Roth IRA once you have maxed out your allowable contributions to a qualified employer sponsored plan (401k) and direct contributions to an IRA, a mega backdoor Roth may be an option. The concept of a mega backdoor Roth involves utilizing an employer sponsored 401k plan to make a Roth contribution well in excess of the current 401k individual contribution limit of $19,500 plus catch up contribution, if applicable.
- Who Is Eligible?
To be eligible, you must be a participant in a 401k plan that (1) allows after-tax contributions and (2) permits in-service withdrawals or rollovers. Many employers do not allow participants to make after-tax contributions as it could cause the 401k plan to fail non-discrimination tests. The IRS non-discrimination tests prohibit retirement plans from offering a substantially larger benefit to higher income employees.
2. What Is the Process?
The overall contribution limit to a 401k plan for 2021 is $58,000 ($64,500 if age 50 or older). Of that amount, the most a participant can contribute to his or her 401k plan on a pre-tax basis for 2021 is $19,500 ($26,000 if age 50 or older). Any contribution an employer makes to the participant’s 401k is applied toward the overall contribution limit. If the 401k plan allows after-tax contributions, the participant may contribute the remaining amount up to the overall contribution limit. For example, a 39-year-old participant who maxes his pre-tax contribution and receives a 5% employer match may make an after-tax contribution to his 401k of $37,525 ($19,500 + $975 match + $37,525 after tax contribution = $58,000).
Once the participant makes the $37,525 after-tax contribution to his 401k, he would then complete a $37,525 in-service rollover from his 401k to his Roth IRA. Similar to a backdoor Roth, the participant will want to complete the rollover as soon as practical to avoid accumulation of gain that would be taxable on the conversion.
A Backdoor or Mega Backdoor Roth May Not Be Right for You
Even if you are a participant in an eligible 401k plan and have extra cash to invest, contribution to a Roth through a backdoor conversion may not be right for you. Before pursuing a backdoor conversion, you should first consult with a tax and financial advisor about your specific situation.
One issue to consider is the pro-rata rule that applies to withdrawals from tax deferred vehicles. The pro-rata rule is the formula that is used to determine how much of a distribution is taxable when the account holder has a mix of both after-tax and pre-tax dollars in a qualified account such as a traditional IRA or a 401k. The account holder cannot withdraw only the after-tax contributions. Rather, the account holder must withdraw an amount equal to the ratio of his or her contribution sources. Accordingly, a backdoor Roth works best for someone who does not have an existing IRA. This allows a $6,000 contribution of after-tax dollars to a traditional IRA with a $0 balance and a corresponding $6,000 conversion to a Roth IRA with little tax consequence. It is rare that someone hoping to do a mega backdoor Roth would have a 401k with a $0 balance. Even if a 401k participant had a $0 balance at the beginning of the year and only made contributions to the Roth portion of his/her 401k, he/she could still have pre-tax contributions at the end of the year as any employer contributions must go into the traditional 401k. In short, you must consider the tax consequences of a Roth conversion before pursuing a backdoor or mega backdoor Roth.
EBS is not an accounting or law firm and the foregoing is a general summary of the rules and limitations that may apply to you. It is not intended to apply to all persons and situations, and you should contact your tax or legal professional for advice. Please contact a member of the Wealth Management Group to discuss your specific situation.
Data provided has been obtained by third party sources. This data, while believed to be reliable, has not been independently verified by EBS.