Retirement planning is a crucial aspect of financial wellbeing, and tax-free investment vehicles like Roth IRAs are increasingly popular among investors.
However, high-income earners face certain limitations and restrictions when contributing to traditional Roth IRAs.
In such scenarios, Backdoor Roth IRAs offer a viable alternative for creating tax-free retirement income.
The Backdoor Roth IRA strategy allows individuals who exceed the income limits for Roth contributions to convert their traditional IRA after-tax contributions into Roth contributions.
Two popular types of Backdoor Roth IRAs are Regular Backdoor Roth and Mega Backdoor Roth.
In this guide, we will explore the key differences between Mega vs Regular Backdoor Roth and help you decide which strategy is suitable for your retirement goals.
Introduction to Backdoor Roth IRA
A Roth IRA is a popular retirement savings option that allows individuals to contribute after-tax dollars to their retirement accounts, which then grows tax-free and can be withdrawn tax-free.
However, the IRS imposes income limitations on who can contribute to a Roth IRA.
The limit for 2021 contributions to a Roth IRA is $6,000 per year for those under 50, while the limit for those over the age of 50 is $7,000.
This limit is reduced or eliminated at certain income levels, meaning high-income earners might not be eligible for direct Roth IRA contributions.
However, there is still a way for these high earners to build their retirement nest egg tax-free using the Backdoor Roth IRA strategy, which involves converting traditional IRA contributions into Roth IRA contributions.
Explaining Regular Backdoor Roth
A regular backdoor Roth involves converting traditional IRA contributions into Roth contributions.
This method allows people who exceed the Roth contribution income limits to continue contributing to their Roth IRA.
There are typically no income limits governing how much someone can convert, as long as they’ve earned at least enough income to justify the contribution.
With a traditional IRA, contributions are made with pre-tax dollars, meaning they are tax-deductible in the year they are made and are only taxed when the funds are withdrawn at retirement.
Here’s how the Regular Backdoor Roth process works:
- Make a non-deductible contribution to a traditional IRA account.
- Convert the money from the traditional IRA account to a Roth IRA account.
- Pay taxes on any pre-tax funds in the traditional account and any earnings on the money you rolled over to the Roth IRA.
Contribution limits and considerations
One important consideration of a Regular Backdoor Roth is the annual contribution limit for traditional IRAs.
For 2021, the traditional IRA contribution limit is $6,000, with a catch-up contribution of $1,000 for people over 50.
It’s important to note that the IRS taxes any untaxed funds in a traditional IRA at the time of conversion to a Roth IRA, meaning the more untaxed growth that has accumulated in the traditional account, the greater the potential tax bill will be.
Tax implications
While a Regular Backdoor Roth allows high-income earners to keep contributing to their Roth IRA, it’s important to consider the tax implications before proceeding with the conversion.
Any pre-tax contributions or earnings in the traditional IRA account will become taxable income at the time of the Roth conversion, which can create a large tax bill depending on the amount converted.
However, after the conversion is complete, all future withdrawals, including earnings, will be tax-free as long as certain conditions are met, which can help lower overall tax bills in retirement.
Pros and cons
Here are some pros and cons of Regular Backdoor Roth:
Pros:
- Allows high-income earners to continue contributing to their Roth IRA.
- Future tax-free withdrawals including earnings help lower overall tax bills in retirement.
- No limits on how much can be converted from traditional IRA to Roth IRA.
Cons:
- Can create a large tax bill at the time of conversion, depending on the amount converted.
- Careful tracking of contributions and conversions is necessary to avoid running afoul of IRS rules.
- Those with significant untaxed income or gains in their traditional IRA may find themselves with a sizable tax liability at conversion.
Understanding Mega Backdoor Roth
A Mega Backdoor Roth is a variation of the Backdoor Roth strategy – but it allows contributions in the range of $38,500 – $58,000 as compared to a Regular Backdoor Roth.
It’s more appropriate for individuals with higher incomes, and it allows them to save more aggressively.
The Mega Backdoor Roth is offered as a voluntary after-tax contribution to either traditional or Roth 401(k) plans, depending on the plan provider and set-up of the company’s 401(k).
It has a higher contribution limit and allows high-income earners to contribute even more than they could with a Regular Backdoor Roth IRA.
The contribution limits can vary depending on the 401(k) plan and the individual’s income but is generally 2% of their annual salary.
Contribution limits and options for high earners
The contribution limits for Mega Backdoor Roth are much higher. For 2021, the contribution limit is $38,500 for those with income less than $200,000 (single) or $125,000 (married filing separately), meanwhile, it is $58,000 for those with income more than $200,000 (single) or $125,000 (married filing separately).
Another key consideration with the Mega Backdoor Roth is that the contribution is an after-tax contribution, meaning you’ve already paid taxes on the income you’re contributing.
Since after-tax money is in a retirement account, it can grow tax-free and be withdrawn tax-free in retirement just like a Roth IRA.
Employer-sponsored plans and requirements
Mega Backdoor Roth contributions are voluntary and are typically offered through employer-sponsored 401(k) plans.
In order to take advantage of the strategy, the employer’s retirement plan must allow after-tax contributions and in-service withdrawals, which are withdrawals taken while the employee is still working for that company.
Tax implications
Mega Backdoor Roth contributions allow investors to take advantage of tax-free growth and withdrawals in retirement.
Unlike traditional IRAs, there are no required minimum distributions (RMDs) in Roth IRAs, meaning you won’t be forced to make withdrawals that could bump you into a higher tax bracket.
Pros and cons
Here are some pros and cons of Mega Backdoor Roth:
Pros:
- Allows high-income earners to contribute more for tax-free retirement.
- After-tax contributions can grow tax-free and be withdrawn tax-free in retirement.
- No required minimum distributions (RMDs) in Roth IRAs.
Cons:
- Availability of the Mega Backdoor Roth investment option depends on the employer and type of 401(k) plan offered.
- Employer restrictions and plan requirements can impact ability to invest in the Mega Backdoor Roth.
- Could be expensive to fund contributions, particularly if the employer does not offer matching contributions.
Mega vs Regular Backdoor Roth: All The Key Differences Discussed
While both Mega and Regular Backdoor Roth options allow investors to build their retirement nest egg tax-free, there are several key differences between the two.
Contribution limits and allowances
Regular Backdoor Roth contributions are limited to the annual contribution limit of $6,000 (or $7,000 for those over 50), while the contribution limit for Mega Backdoor Roth is much higher and can range between $38,500 and $58,000.
Income requirements and eligibility
While both Regular Backdoor Roth and Mega Backdoor Roth allow high-income earners to contribute to their Roth IRA, the income thresholds differ.
Regular Backdoor Roth is available to individuals with a modified adjusted gross income below $139,000 for single filers and $206,000 for joint filers, whereas Mega Backdoor Roth is available to those earning above these limits.
Tax implications and considerations
The Regular Backdoor Roth has a potentially larger tax bill at the time of conversion, as it requires the conversion of already tax-advantaged contributions.
In contrast, Mega Backdoor Roth’s after-tax contributions grow and can be withdrawn tax-free in retirement which makes it more favorable.
Flexibility and withdrawal options
The Regular Backdoor Roth has greater flexibility with regard to when and how contributions are made, while the Mega Backdoor Roth depends on the employer.
Regular Backdoor Roth withdrawals from the account after age 59.5 years are tax-free, as long as the Roth IRA account has been open for at least five years.
The Mega Backdoor Roth is much more flexible and offers tax-free withdrawals as long as the contribution has been made for five years and the account holder has reached age 59.5.
Conversion strategies and rollover possibilities
Regular Backdoor Roth requires the conversion of traditional IRA contributions – which includes the tax-deferred gains on those investments – while Mega Backdoor Roth allows you to invest after-tax money into a Roth IRA for tax-free growth in retirement.
Regular Backdoor Roth allows conversion of the excess contributions to Roth IRA while Mega Backdoor Roth allows those who have left their employer to rollover their contributions to a Roth IRA.
Considerations for high-income earners
High-income earners who do not qualify for traditional Roth IRA contributions need to ensure they are investing in a retirement fund without any traditional IRA assets when converting contributions to a Roth IRA.
Choosing the Right Strategy for Your Financial Goals
Choosing the right strategy for your retirement goals depends on several factors. Consider the following points when making a decision:
Employer plan and type of 401(k) offered
Check if your employer’s retirement plan provides the option for Mega Backdoor Roth contributions.
This strategy is limited to employers who offer after-tax contributions and in-service withdrawals.
Current contribution and saving rate
Evaluate your current contribution and saving rate to determine if it aligns with your retirement goals.
Consider your ability to fund the contributions required for both Regular Backdoor Roth and Mega Backdoor Roth.
Willingness to pay the tax bill and income requirements
Regular Backdoor Roth conversions can result in a sizable tax bill, depending on the amount being converted. Determine if you are willing and able to pay the tax bill associated with the conversion.
Also, consider whether you meet the income requirements for Regular Backdoor Roth.
Financial goals and retirement plans
Consider your long-term financial goals and retirement plans. Determine which strategy aligns better with your goals and helps you maximize your tax-free retirement savings.
Consultation with a financial advisor
Partnering with a financial advisor can provide valuable guidance when choosing between Regular Backdoor Roth and Mega Backdoor Roth.
A financial advisor can help analyze your financial situation, goals, and retirement plans to determine the best strategy for you.
Frequently Asked Questions
Can I have both a regular and mega backdoor Roth?
Yes, there’s no limit to the number of Roth IRA accounts an individual can have.
Is the Mega Backdoor Roth legal and compliant?
Yes, Mega Backdoor Roth strategies are legally compliant, as long as they meet the specific IRS and employer plan requirements.
What happens if I exceed the contribution limits?
Over-contributing to a Backdoor Roth IRA could result in penalties, and you may be subject to taxes on the excess contribution.
Can I convert a Regular Backdoor Roth to a Mega Backdoor Roth?
No, you cannot convert a Regular Backdoor Roth into a Mega Backdoor Roth as they are fundamentally different strategies.
Conclusion
In conclusion, both Mega and Regular Backdoor Roth strategies offer viable alternatives for high-income earners to build their retirement nest egg tax-free.
Each strategy has its pros and cons, and the choice ultimately depends on your financial goals, whether you qualify for traditional Roth IRA contributions, and the type of 401(k) plan your employer offers.
Take the time to determine which method is best for you and partner with a financial advisor to put your plan into action.
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