Backdoor & Mega Backdoor Roth Strategies
A Backdoor Roth is a process that allows anybody with earned income to contribute to a Roth IRA, even if they are above the IRS income limits.
It works by contributing to a traditional IRA as an after-tax, non-deductible IRA contribution, meaning that you won’t take the tax deduction for the contribution but will not be subject to income limitations. You then immediately convert it into your Roth IRA. Because you made a non-deductible IRA contribution, you will have a tax basis equal to the amount you convert, effectively making it non-taxable. If there are any earnings, they are taxable, but since they’re usually only over a few days if you convert quickly, the gains are negligible, if not $0.
There is an aggregation and pro-rata rule you should consider when converting from a traditional IRA to a Roth. On December 31 of the year of the Roth conversion, the total amount of your traditional, SEP and SIMPLE IRAs must be $0; otherwise, you may be taxed based on a proportionate value of all of your pre-tax IRA accounts. The pro-rata rule can be a reason to leave money in a workplace 401k instead of rolling it into an IRA. In fact, some 401k plans allow you to reverse rollover, transferring your IRA back into your 401k account, which can help avoid this pro-rata rule.
Mega Backdoor Roth
A Mega Backdoor Roth is a way to contribute more than the elective deferral limit for a 401k into a Roth account (typically a Roth 401k, sometimes a Roth IRA). Although the elective deferral limit for a 401k is $23,000 in 2024, the combined contribution limit is $69,000 in 2024, which includes elective deferrals, employer match, and after-tax contributions. For example, if you receive a $5,000 employer match, you have a $41,000 limit remaining for after-tax contributions.
Similar to a Backdoor Roth, you would then convert it into a Roth account either into your Roth 401k (via an in-plan rollover) or your Roth IRA (via an in-service withdrawal). It is important to note that many plans do not allow or limit after-tax contributions, which would mean you are ineligible to perform a Mega Backdoor Roth.
Unlike a Backdoor Roth, there is no aggregation of pre-tax accounts of your IRA accounts to worry about. However, any earnings on your after-tax contributions before Roth conversion will be subject to income tax. You can minimize taxable earnings by converting shortly after contributing to your after-tax account.
When Should I Consider a Backdoor Roth or a Mega Backdoor Roth
If you are above the income limits for a Roth IRA and are already maxing out the elective deferrals for a 401k and other tax-advantaged accounts (e.g., HSA/FSA), you may be a good candidate for either (or both) of these strategies. Unlike a taxable account, which will be subject to capital gain rates and annual taxation on distributions & dividends, a Roth account will be taxation-free as long as you meet the requirements (generally waiting until you’re 59.5 and meeting a 5-year waiting period since the conversion). Although you can always access your taxable account money, the principal of your Roth IRA can be accessed penalty-free before retirement age. For a Roth 401k, it depends on your plan rules, but one way to access it is to roll it over to your Roth IRA (typically when you leave your employer) and withdraw on the principal. These Roth accounts aren’t as liquid as your taxable account, so it’s best for long-term investments.
Article Post Disclaimer
Astra Wealth Partners LLC is a registered investment adviser registered with the United States Securities and Exchange Commission.
Registration does not imply a certain level of skill or training. The views and opinions expressed are as of the date of publication and are subject to change. The content of this publication is for informational or educational purposes only. This content is not intended as individualized investment advice, or as tax, accounting, or legal advice. Although we gather information from sources that we deem to be reliable, we cannot guarantee the accuracy, timeliness, or completeness of any information prepared by any unaffiliated third-party. When specific investments or types of investments are mentioned, such mention is not intended to be a recommendation or endorsement to buy or sell the specific investment.
The author of this publication may hold positions in investments or types of investments mentioned. This information should not be relied upon as the sole factor in an investment-making decision. Readers are encouraged to consult with professional financial, accounting, tax, or legal advisers to address their specific needs and circumstances.