Individuals looking to boost their retirement savings beyond the traditional limits of workplace 401(k) and 403(b) plans may be able to do so with a mega backdoor Roth. This strategy may provide a workaround to the income and contribution limits of Roth IRAs while allowing high-net-worth individuals to benefit from tax-free distributions in retirement.
For many, saving for security in retirement begins with annual pre-tax contributions to an employer’s 401(k) or 403(b) plan, which maxes out at $23,000 in 2024 (or $30,500 if age 50 or older). The amount you contribute to these plans reduces your taxable income in the year of contribution and grows tax-deferred during your career. When withdrawn in retirement, the distributions will be treated as taxable ordinary income to you.
This strategy may work well for high-income earners who need a tax break today and expect to be in a lower income tax bracket during retirement. However, this may not be the case for high-net-worth individuals with the means to save more than the IRS allows today, during their prime earning years, and who do not expect a drop in income when they retire. For those savers, a mega backdoor Roth should be considered when available.
Differences Between Traditional Retirement Plans and Roths
Before getting into the details of how a mega backdoor Roth can occur, it is important first to understand some of the critical differences between a traditional retirement plan and a Roth. Following are some examples:
Maximizing 401(k) Excess Savings with Roth Conversions
Some 401(k) plans include specific language allowing participants to make after-tax contributions above the employee deferral limit. In 2024, the maximum amount that can go into a 401(k) plan is $69,000, which is the sum of 1) the employee contribution ($23,000 for employees younger than 50), 2) any employer match or profit sharing, and 3) the employee’s after-tax contribution. If the plan allows for after-tax contributions but does not have an employer match, employees may max out their 401(k) plan contributions in 2024 with $23,000 pre-tax and make a separate excess contribution of as much as $46,000 ($69,000 – $23,000) with after-tax dollars.
If left in the after-tax bucket, the excess contribution would grow tax-deferred until withdrawn in retirement. At that point, income tax would be due only on the investment gains attributed to the excess contributions.
Despite this ability to supersize retirement savings, the real value comes when plan participants convert their after-tax 401(k) contributions to a Roth account inside the 401(k) plan.
Here’s how it would work:
Consider that John maxes out his 401(k) plan in 2024 with salary deferrals totaling $23,000. Because his employer’s plan allows for after-tax contributions, he contributes an additional $40,000 and earns $100 in interest. At the end of the year, he converts the entire $40,100 in after-tax money to his Roth 401(k) account, where he will pay income taxes only on the $100 of interest.
John now has $40,000 in his Roth account, growing tax-deferred. If John holds the Roth account for a minimum of five years, he may take income-tax-free withdrawals from the account after he turns age 59.5. John can repeat this process every year, creating a mega Roth account for added security during his retirement.
The rules and processes for completing a mega backdoor Roth are complex and require an employer’s 401(k) plan to include appropriate language and pass annual IRS compliance testing. The professionals with Provenance Wealth Advisors (PWA) help businesses design and implement ERISA-compliant benefit plans while also providing high-net-worth families with tax-efficient investment and estate planning services.
About the Author: Sean Deviney is a CFP®* professional, a retirement plan advisor and a director with Provenance Wealth Advisors (PWA), an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors + CPAs and a registered representative with PWA Securities, LLC. He can be reached at the firm’s Fort Lauderdale, Fla., office at (954) 712-8888 or info@provwealth.com.
Provenance Wealth Advisors (PWA), 200 E. Las Olas Blvd., 19th Floor, Ft. Lauderdale, FL 33301 (954) 712-8888.
Sean Deviney, CFP®*, is a registered representative of and offers securities through PWA Securities, LLC, Member FINRA/SIPC.
This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct.
Any opinions are those of the advisors of PWA and not necessarily those of PWA Securities, LLC. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of PWAS, we are not qualified to render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professional. Prior to making any investment decision, please consult with your financial advisor about your individual situation.
401(k) plans are long-term retirement savings vehicles. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59½, and may be subject to a 10% federal tax penalty. Investments mentioned may not be suitable for all investors. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct.
Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion. Please note, changes in tax laws may occur at any time and could have a substantial impact on each person’s situation. While we are familiar with the tax provisions presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.
* Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™ and federally registered CFP (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.
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Posted June 6, 2024