Demystifying Mega Backdoor ROTH’s – and why it is important to know them
I am sure that at some point or another you have been part of a conversation where someone says that their company has a mega backdoor ROTH and you wonder how that exactly works and why you don’t have one? Or you have seen or heard some TV pundit wax eloquent about these? Let us demystify it for you while giving you some actionable information.
First of all – what is a ROTH and why does everyone seem to like them?
Here’s how they work:
Unlike your traditional tax deferred 401K’s or IRA’s, ROTH IRA’s are contributed with after tax money.
After age 59 ½ (and like traditional IRA’s), there is no 10% penalty for withdrawals.
Unlike the traditional IRA or 401k, ROTH IRA’s have no Required Minimum Distribution (RMD), currently at age 73.
And the MOST important reason, the gains in a ROTH IRA are TAX FREE.
However, there are always caveats. The IRS does not want high earners to be able to use a ROTH. Accordingly, they are classified as income earners earning over $228,000 annually (married filing jointly) or $153,000 (filing single). If your income is at or above these limits, you will not be able to contribute to a ROTH.
Enter the “Mega Backdoor ROTH”
The name is catchy thanks to creative people coming up with catchy titles. The ‘official’ name is Post Tax Contribution. What is it exactly? Some companies (especially larger ones) offer a post-tax contribution option to their employee 401k plans. If you thought that all that you could contribute to your 401K was $20,000 (under age 50), think again. The magic number is $66,000 (under age 50 without the age 50+ catchup). Here is an example:
In 2023:
You contribute $20,000 to your 401k
Your company 401K match totals $10,000 (IF it has a 401k match)
Now, your total 401k amount total $30,000.
With me, so far? Great, now for the grand finale.
Your total that you CAN contribute IF your 401K plan allows is $66,000.
You still have $36,000 available to contribute to a ROTH like instrument, the Post Tax contribution or the more catchy title ‘Mega Backdoor ROTH’. Essentially, you can contribute another $36,000 to a ‘ROTH’ IF your plan allows for that – regardless of your salary and income levels – IF your 401K plan allows for this contribution.
Obviously, if your company allows for this and you monthly cash flow after expenses allows you to contribute the maximum amount, your ROTH IRA is starting to look really good over the years. In this scenario, you CAN contribute to a ROTH, and much higher than the $6,500 per year (2023) limit, regardless of how much you make! How about that for a mega backdoor!
What if your employer does not offer the ‘Mega Backdoor ROTH’?
Well, that will be too bad, of course. However, you do have options:
If you are a W-2 employee, ask your employer why they don’t have this option. It is not that expensive to add on this feature to the 401k plan. If your employer says that it is too expensive to add this, then maybe it is time for them to shop around for a new 401k provider!
If you are a business owner, then there is good news. You can set up your own 401k plan, engage your own recordkeeper and have the freedom to add a mega backdoor ROTH as well as a Cash Balance plan if you are able to put more money away tax deferred.
If you are W-2 employee AND have 1099 income from a side gig, yes, you can set up your own Solo 401K with mega backdoor ROTH and cash balance plan – if it makes sense to do so. For example, you can only contribute to your employer 401k or your Solo 401k for a total of $20,000 for the year.
Hopefully, that gives you a high level understanding of not only the Mega Backdoor ROTH but also sone options if your employer does not offer. At Capital V Group, we assist our business owner and sole proprietor clients set up these plans with professional guidance to that they can leverage tax benefits and saving for the future while they are focused on growing and running their businesses.
Please reach out to us if you have questions and for a complimentary consultation on this topic. Savings and investments compound over the years. The sooner you start, the higher the number at the end due to compounding in the way. Don’t let procrastination get in your way. Inaction does have a steep price.
Note: This material was created to provide accurate and reliable information on the subjects covered but should not be regarded as a complete analysis of these subjects. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation
Arvind Ven is a Registered Representative with and Securities and Advisory Services offered through LPL Financial, a Registered Investment Advisor. Member FINRA & SIPC. Financial planning offered through Capital V Group, a registered investment advisor and a separate entity from LPL Financial.