How Does a Mega Backdoor Roth Work?

September 8, 2020

Many people are curious as to what exactly a Mega Backdoor Roth IRA is and how it works. This was once a well-kept secret by certain retirement planners. It usually applies to individuals who earn way too much to contribute to an ordinary Roth IRA. In recent times, the IRS has released some instructions that include information on Mega Backdoor Roth IRA. To benefit from a Mega Backdoor Roth IRA, it requires that you have an employer 401(k). This 401(k) must allow after-tax contributions.

 

What is a Mega Backdoor Roth IRA?

The process of making an after-tax contribution to an ordinary IRA account and then transforming those funds to a Roth IRA is referred to as a Mega Backdoor Roth IRA. This conversion is possibly subject to taxation. How taxation is applied to these funds depends on whether you already have funds in a traditional IRA that was contributed on a pre-tax basis. Taxation also depends on whether the funds in the account represent earnings on the contributions. 

This strategy is an incredible way for high-income earnings to contribute much more funds in a Roth IRA account. Employing the Mega Backdoor Roth IRA strategy means that contributors will make after-tax contributions beyond the usual annual contribution limits of the 401(k) plan that their employers have organized.  Using this strategy could mean that highly paid employees can contribute as much as an extra $37,500.

 

How Mega Backdoor Roth IRA Work?

Take a deep breath and grab your thinking cap as we navigate how this plan works. Be prepared to read this once more so that you can fully grasp the concept.

In order for you to effectively use this strategy, your employer must allow after-tax non-Roth contributions to be made to your plan. These funds are contributed to a separate collection of funds, and the amount contributed is way above the regular limits of the original 401(k) plan.

As of 2020, the maximum that can be contributed above the normal limits of a plan such as a 401(k) is $37,500. Bear in mind that the standard limit for a Roth 401(k) in 2020 is $19,500 or $26,000 for individuals at or beyond the age of 50. Check with your employer if the 401(k) plan they offer allows this. Approximately 40% of 401(k) plans allow for this over the limit contribution.

You will need to find out if your employer permits in-service non-hardship withdrawals. Most plans allow this even below the stipulated 55 or 59 ½ age limits. Nevertheless, this strategy can still work without this.

If you are able to make these contributions, you will need to factor in what your employer is contributing as a matching figure. So, if your employer contributes $7,000, you will only be able to contribute an additional $30,500.

After determining how much you can actually contribute beyond the limit, you will then do an in-service non-hardship withdrawal as a rollover to a Roth IRA account. Doing this as a rollover will help you to avoid attracting early withdrawal taxes and penalties.

If you want to contribute to a Roth IRA or you want to build up a large amount of funds in your Roth IRA account, this strategy is perfect for you.

Rahul Iyer