A Mega Backdoor Roth for Mega Long-Term Wealth
Are you ignoring a game-changing way to build tax-free wealth with a Mega Backdoor Roth?
Are you a high-earner under 50?
Do you have your Emergency Fund established & enough cash for your short-term needs?
Do you have savings to invest after maxing out contributions to your 401K ($19,500), IRA ($6,000), & HSA ($3,550-single/$7,100-family)?
Does your employer’s 401k plan have a Roth option, allow “after-tax contributions” (different from Roth contributions), & allow in-plan conversions?
Are you looking for a way to supercharge your long-term wealth?
If you answered yes to all five questions, great job! You’re making some savvy financial moves. As a reward, I’m going to tell you how you can put rocket boosters on your ship to financial independence by implementing a Mega Backdoor Roth strategy. In a previous post, I described the benefits of a Roth 401k for certain high-earners. You can check it out here. In this post I’ll give you a breakdown of the incredible power of the Mega Backdoor Roth, and why all younger high-earners should be considering this. So, what’s a Mega Backdoor Roth?
A QUICK REFRESHER – ROTH VS. TRADITIONAL
While both Roth and Traditional retirement accounts offer you tax benefits, the tax benefits are essentially the reverse of one another. With Traditional contributions you get an upfront income tax break on your contributions in exchange for owing income tax on 100% of your withdrawals in the future. With a Roth account you’ll owe income tax on your contributions in the current year in exchange for never owing another dime of federal income tax on that money, or it’s compounded earnings, again – assuming some basic conditions are met. In other words, it’s a fantastic planning tool that lets you build a bucket of tax-free retirement assets, diversify the taxability of your investments, and reduce your total lifetime taxes!
ISSUES FOR HIGH-EARNERS
There are limits on who can use a Roth account and how much you can contribute to them. If you have access to a Roth option in your 401K, you can contribute up to $19,500/year in that account regardless of your income. You can also contribute up to $6,000/year in a Roth IRA if your Modified Adjusted Gross Income (MAGI) is less than $125,000 (Single) or $198,000 (Married Filing Joint) in 2021.
As a high-earner, there are generally three issues preventing you from building up your Roth accounts. One, you can’t contribute directly to a Roth IRA because your income is too high. Two, your income puts you in a higher tax bracket, which means that even if you have access to a Roth option in your 401K/403B, you might prefer to max out your $19,500 in Traditional 401K contributions instead. Doing so could save you $7,215/year in taxes (if you’re in the 37% tax-bracket), potentially making that the preferred option. Three, doing run of the mill Roth conversions with your Traditional accounts is going to cost you an arm and a leg in taxes at your current marginal rate.
So then, what’s the most effective way to build up tax-free Roth assets in such a scenario? You’re basically left with two options. Determining which is better for you will depend on your scenario and objectives. Your first option – a standard Backdoor Roth IRA – is great if you don’t have any Traditional IRA accounts funded AND you’re looking to invest $6,000/year or less in your Roth. Your second option is to use your current 401k to implement a Mega Backdoor Roth strategy. A Mega Backdoor Roth can work even if you have Traditional IRAs funded and/or you want to invest more than $6,000/year in your Roth. Keep in mind that the specifics of each plan and each individual makes every case unique. As such, this is a strategy best accomplished with the help of a fee-only planner to help guide you through everything and keep you from running into any potentially costly errors or issues. So, how does a Mega Backdoor Roth strategy work and what are the benefits? To start, it’s important to know that the tax code allows for up to $58,000/year in total 401k contributions. Now, let’s look at a hypothetical example to see how exactly this all works:
You’re 40, filing single, and earn $300,000 a year, placing you in the 35% marginal bracket. You contribute 6.5% ($19,500) to max out your Traditional 401K contributions so you can reduce your taxes this year by $6,825. Your employer offers a full match on the first 3% for annual employer contributions of $9,000/year and total 401K contributions of $28,500/year. We’ll assume that you answered “Yes” to the questions at the top of this post and that you have extra savings you want to use to build a pool of tax-free retirement assets. With the $58,000 limit, you’d be able to make another $29,500 in after-tax contributions to your 401K plan in the current year.
To implement the Mega Backdoor Roth strategy, first you’ll need to take your number of pay periods per year and divide your desired after-tax contribution by that number to determine how much you’ll want to contribute to your after-tax account each paycheck. Next, you need to contact your Plan Administrator and set up periodic in-plan conversions of JUST your after-tax contributions and any minimal amounts of associated earnings to your Roth account. Ideally, you will want to set up these in-plan conversions as frequently as is permissible so you can minimize the amount of earnings generated by your after-tax contributions. This is crucial because the earnings attributed to your after-tax contributions will be taxable to you at your marginal income rate when converted to your Roth account. I’ll say it again because it’s that important, once you begin making after-tax contributions, you’ll want to get the money converted to your Roth account ASAP. For the sake of ease in this example, we’ll assume your total in-plan Roth conversions for the year consisted of the $29,500 of after-tax contributions and $1000 of taxable earnings. You would end up paying 35% on just the earnings portion, which would mean an additional $350 in tax due for the year.
To summarize, at the end of the year you would have accomplished the following:
1. You made $19,500 in Traditional 401k contributions and saved $6,825 in federal income tax.
2. You received your total available company match of $9,000 and did not leave any “free money” on the table.
3. You got $30,500 invested in a Roth retirement account at a total additional tax cost of only $350.
4. You got $30,500 invested in a Roth in a year in which you otherwise COULD NOT directly contribute any money into a Roth IRA AND you did so without sacrificing your ability to max out your Traditional 401k and receive that $6,825 upfront tax break.
5. You got $30,500 into a Roth account without the use of a Traditional to Roth conversion, which for the same amount ($30,500) would have cost you $10,675 in additional taxes at your 35% marginal rate.
6. Here’s the big one. If this was the only money you ever put into a Roth account, you left it untouched and invested in your Roth 401k until age 70, and got an assumed 9% annualized rate of return, you would have approx. $371,251 in TAX-FREE assets available for withdrawal! Or, you could roll the money into a Roth IRA and get decades more tax-free compounded growth!
WHAT’S THE ALTERNATIVE?
This question should ALWAYS be asked in financial planning.
If instead we assume you invested your savings in an identical portfolio in a taxable brokerage account for long-term growth purposes, the following would be true:
1. You would save $350 in taxes since you wouldn’t need to realize any gains from any conversions. In this example I’ll add that $350 to the investment in your taxable account.
2. At the end of the year, you would have $30,850 invested in a taxable account designated for long-term growth, with a cost basis of $29,850.
3. You would have $0 in Roth (tax-free) retirement account assets.
4. If this was the only money you invested in your taxable investment account, you left it untouched and invested until age 70, and you got the same 9% annualized rate of return, you would have a balance of approx. $375,512. For the sake of ease and to be overly conservative, in this example I’m not accounting for any taxes being taken out along the way. In reality, taxes would be owed and the end balance would be significantly lower.
5. If you were to sell your positions and withdrawal the money, you would have a realized long-term capital gain of $345,661 and $29,850 in tax-free return of cost-basis. The $345,661 gain would be taxed at whatever the Long-Term Capital Gains rate & Net Investment Income rates are at that time. If we assume the current 15% LTCG and 3.8% Net Investment Income tax rates, you would have approx. $310,526 available after taxes for withdrawal. $345,661 x 81.2% = $280,677 + $29,850 cost basis. This is $60,725 LESS than if you had invested the same amount using the Mega Backdoor Roth strategy
ITEMS TO NOTE
This is JUST ONE YEAR of doing a Mega Backdoor Roth! If you were to implement the Mega Backdoor Roth strategy over multiple years, the results become SIGNIFICANTLY more dramatic! Also, if you adjust the assumptions I made and you extend the time frame, assume a higher rate of return, or assume higher future LTCG/NII tax rates, the end balances are higher and the resulting differences get even bigger. Lastly, I’m being overly conservative in the taxable account example because I’m not factoring in any taxes being taken out during the growth years. In reality, taxes would be owed on capital gains and dividend income over the years which would result in a much lower final balance. In short, in a similar real-life scenario there would be an even bigger difference in the after-tax available balance at age 70 than what is shown in these examples.
Here are 4 major takeaways: One, getting a large sum invested early and letting compounding do its magic leads to significant long-term growth regardless of the account used. Two, if you can find a way to get that large sum invested in a tax-free account using a Mega Backdoor Roth strategy, you will benefit from diversifying the tax treatment of your retirement assets and you’ll receive a substantial boost to your long-term wealth. Three, when executed over multiple years, this strategy can have a dramatic impact on your financial wellbeing. Four, it’s important to have a thorough understanding of your 401k plan and know the finer points of how it functions and what it permits to make sure you’re not missing out on opportunities like this to supercharge your wealth and speed up your journey towards financial independence. On that point, this is a complex planning technique. There are a lot of important details and rules (and exceptions to rules) that are beyond the scope of this post. There are also other, slightly different methods to successfully executing a Mega Backdoor Roth even if your plan lacks some of the features mentioned in this piece. Accordingly, I highly recommend that you find a fee-only and fiduciary financial planner who can review your plan documents and help you determine if a Mega Backdoor Roth strategy could be appropriate for you. If your plan doesn’t have certain specific features and/or you implement this technique incorrectly, there is the potential for you to make some costly mistakes. I encourage you to seek guidance before taking the leap on this incredibly powerful strategy.
THE BOTTOM LINE
Roth accounts are one of the best tools available in any financial planning tool kit. The Mega Backdoor Roth strategy is one way to pump up your Roth balances extremely quickly with tremendous cost and tax efficiency when executed properly.
If you’re interested in learning more, feel free to get in touch.
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Robert Stromberg, and all rights are reserved. Read the full Disclaimer