The Mega Backdoor Roth has been extended into 2022. What is a Mega Backdoor Roth? How Does it differ from a Backdoor Roth and is it something you can or should take advantage of?
We will explain all the details here so you can make an informed decision.
What is a Mega Backdoor Roth?
The word “Mega” when used with the term “Backdoor Roth” typically refers to a large amount of after-tax money put into your 401(k), then taking these after-tax contributions from your 401(k) and converting them into a Roth IRA (Individual Retirement Account). The word “Mega” comes up synonymously with your 401(k) but it is not always the case.
What is the difference between a Backdoor Roth and a Mega Backdoor Roth?
First, keep in mind that “Mega Backdoor Roth” and “Backdoor Roths” are industry terms. They are not IRS or Department of Labor terms. There are a lot of similarities between Backdoor Roths, and Mega Backdoor Roths but there are some big differences in how they get used, in tandem or in exchange for, each other.
The big differences between the two lies in their contribution limits.
Backdoor Roths came into play by making after-tax IRA contributions. Because there are income limits with Roth IRA contributions, if you make too much money, you are not eligible to contribute even if you want to contribute. On the other side, if you are eligible, you may not have enough earned income to make an IRA contribution. What people do that are not eligible for a Roth IRA contribution is to make a Backdoor Roth contribution instead. There are currently no income limits on conversion so someone potentially could take the after-tax IRA contribution and convert it to a Roth IRA.
Backdoor Roth example
If you make a $6,000 after-tax contribution into an IRA, that $6,000 will grow tax deferred. People are taking the after-tax money they put into a traditional IRA, since they had already paid the tax on it, and making a conversion to a Roth IRA, effectively paying no tax on the conversion. By doing this, they were making a nondeductible IRA contribution and converting it into a Roth IRA. The biggest limitation to this is that you can only contribute up to $6,000 in a year.
A potential issue with a Backdoor Roth conversion for higher net worth people, and people that have other IRA assets is that you get into pro-rata and IRA aggregation rules. With the example above the person converted after tax money, so in theory, there would be no tax liability, but the IRA aggregation rules say that they will look at all your IRAs. So, if the person had $66,000 in total IRA money, and you made a $6,000 after tax contribution, there will only be $60,000 of pre-tax money.
When you convert the $6,000 of after-tax money, the IRS will look at the overall pot of money and say that 90% of that money is pre-tax money ($60,000 / $66,000). So, when you do the conversion, even though you have converted $6,000 and it is all after-tax, it is going to be deemed 90% taxable.
How the Mega Backdoor Roth is different
With the Mega Backdoor Roth through a 401(k), you do not have the maximum contribution problem that you do with the Backdoor Roth. With the Mega Backdoor Roth, the contribution limits are the maximum that is allowed into a qualified 401(k) plan. Currently, for 2022, the defined contribution limit amounts are $61,000. This means you could put $20,500 off deferrals, plus if you are over age 50, you could put in another $6,500 of catch-up contributions increasing your defined contribution limit to $67,500.
If your contribution deferral limit is $20,500, and the plan document allows you to contribute up to $61,000, you need to do the math between $61,000 and your salary deferral, while making sure to leave room for your company match. You do not want to put so much after-tax money in that there is no room for the company to match.
Why would you utilize the Mega Backdoor Roth?
Effectively, a Mega Backdoor Roth is a large Roth contribution with no income limits on your ability to contribute. We could do another blog on why that is important, but what it means is that you are getting a pot of money growing tax-free and have complete control over your investment choices. You could be 100% stock. You could be 100% bonds. The control is in your hands.
When you turn retirement age and you start generating income, this gives you another source of tax favored money in retirement. It will reduce your required minimum distributions and potentially lower your future tax liability.
You can get $20,000 or $30,000 or more potentially of after-tax contributions, that you would not be able to contribute otherwise and convert to Roth. This is where the word “Mega” comes in.
Weren’t they going to do away with the Mega Backdoor Roth this year?
Yes. The Mega Backdoor Roths were supposed to be eliminated as a part of The Build Back Better plan. The intention was to eliminate the large tax-deferred pots of money for high-net-worth people. They took it off, then added it back on, and now it has been deferred. So as of right now, the thinking is that it will be pushed back if it gets implemented at all. This means that for people this could potentially benefit, there is still some time in the next year for people to take advantage of it.
How do you know if this is something you should take advantage of?
People must ask themselves, am I looking for places to save money and invest in my future retirement? If so, do I have the discretionary money to put into my plan to max out my 401(k) contributions and take advantage of my company match to get tax free growth to create another source of funds? Does this fill, or help fulfill one of the tax savings buckets of my retirement portfolio? This will be a yes for most people.
How do I know if I can utilize a Mega Backdoor Roth?
There is a limited audience who can take advantage of the Mega Backdoor Roth. If you work for a large corporation, you will need to ask for a copy of the summary and description of your retirement plan. The summary plan description will identify if after-tax contributions to the 401(k) are allowed. It is not a Department of Labor issue. It is not an IRS issue. It is at the plan level. One plan could allow up to the defined contribution limits while another plan could limit it to $5,000 of after-tax contribution.
Closely held corporations and smaller plans in general, may also be eligible, buy may have a tough time qualifying for the larger contributions. This is because of the top-heavy limitations, placed on qualified retirement plans. A 401(k) cannot favor the highly compensated executive. There are testing requirements in place to make sure that the plan is not skewed to just benefit the highly compensated. For example, if the highly compensated executive, tries to put in $60,000 and their average employees puts in $3,000, this is not likely to pass the top-heavy testing. For this reason, the Mega Backdoor Roth tends to be applicable to larger plans where there is a lot of asset flow, and they pass the testing limitations.
Still have questions? We are here to help.
If you would like us to look at your retirement and see if you are utilizing the best possible options, we would love to meet with you and learn more about your goals to see if there is a good fit for us to work together. Reach us at 562-432-3783 or [email protected] to schedule a free introductory meeting.