Are you ignoring a game-changing way to build tax-free wealth with a Mega Backdoor Roth?

5 QUESTIONS

Are you a high-income 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 ($23,000), IRA ($7,000), & HSA ($4,150-single/$8,300-married couple/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-income 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-income 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-INCOME 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 $23,000/year in that account regardless of your income. You can also contribute up to $7,000/year in a Roth IRA if your Modified Adjusted Gross Income (MAGI) is less than $161,000 (Single) or $240,000 (Married Filing Joint) in 2024.

As a high-income 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 $23,000 in Traditional 401K contributions instead. Doing so could save you $8,510/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.

THE OPPORTUNITY

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 $7,000/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 $7,000/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 $69,000/year in total 401k contributions in 2024. Now, let’s look at a hypothetical example to see how exactly this all works:

AN EXAMPLE:

Sarah is 40, files her taxes as single, and earns $300,000 a year, placing her in the 35% marginal bracket. She contributes $23,000 to max out her Traditional 401K contributions so she can reduce her taxes this year by $8,050. Sarah’s employer offers a full match on the first 3% of her income for annual employer contribution of $9,000/year, thus bringing her total 401K contributions to $32,000/year. We’ll assume that Sarah answered “Yes” to the questions at the top of this post and that she has extra savings that she wants to use to build a pool of tax-free Roth retirement assets. With the $69,000 limit, she would be able to make another $37,000 in after-tax contributions to her 401K plan in the current year.

To implement the Mega Backdoor Roth strategy, first She will need to take the number of pay periods she has per year and divide her desired after-tax contribution by that number to determine how much she’ll want to contribute to her after-tax account each paycheck. Next, Sarah will need to contact her Plan Administrator and set up periodic in-plan conversions of JUST her after-tax contributions and any minimal amounts of associated earnings to her Roth account. Ideally, she will want to set up these in-plan conversions as frequently as is permissible so she can minimize the amount of earnings generated by her after-tax contributions. This is crucial because the earnings attributed to her after-tax contributions will be taxable to Sarah at her marginal income rate when converted to her Roth account. I’ll stress this again, because it’s that important, once Sarah begins making after-tax contributions, she’ll want to get the money converted to her Roth account ASAP! For the sake of ease in this example, we’ll assume her total in-plan Roth conversions for the year consisted of the $37,000 of after-tax contributions and $1000 of taxable earnings. Sarah would end up paying 35% on just the earnings portion, which would mean that she would only have an additional $350 in taxes due for the year as a result of executing this Mega-Backdoor Roth strategy.

IN SUMMARY

At the end of the year, Sarah would have accomplished the following:

1. She made $23,000 in Traditional 401k contributions and saved $8,510 in federal income tax for calendar year 2024.
2. She received her total available company match of $9,000 and did not leave any “free money” on the table.
3. She got $37,000 invested in a Roth retirement account at a total additional tax cost of only $350.
4. She got $37,000 invested in a Roth account in a year in which she otherwise could not directly contribute any money into a Roth IRA and she did so without sacrificing her ability to max out her Traditional 401k and receive that $8,510 upfront tax break.
5. She got $37,000 into a Roth account without the use of a Traditional to Roth conversion, which for the same amount ($37,000) would have cost her $12,950 in additional taxes at her 35% marginal rate.
6. Here’s the big one. If this was the only money Sarah ever put into a Roth account, she left it untouched and invested in her Roth 401k until age 70, and got an assumed 9% annualized rate of return, Sarah would have approx. $490,904 in tax-free money at age 70! Or, she could leave it in her account for decades more tax-free compound growth and possibly leave these assets to her loved ones as part of her legacy plan given that Roth accounts are now the optimal account to leave loved ones when you pass.

ITEMS TO NOTE

This example is just one year of doing a Mega Backdoor Roth. If Sarah were to implement the Mega Backdoor Roth strategy over multiple years, the differences in after-tax dollars become significantly larger! Also, if we adjust the assumptions I made and extend the time frame, assume a higher rate of return, or assume higher future LTCG/NII tax rates, the resulting differences get even bigger.

MAJOR TAKEAWAYS

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