Before adding terms like “Backdoor” and “Mega” to already confusing investments beginning with the word “Roth,” let us make sure we understand the basics the best we can. We’ll begin with the eligibility requirements of the Traditional IRA, then the Roth IRA, and then describe the "Backdoor" and "Mega" terms.
The benefit of a Roth account is the opportunity to withdraw tax-free funds from the account once five years from opening the account have elapsed and the recipient is over 59½. Another benefit to a Roth IRA is unlike a traditional IRA; there is no Required Minimum Distributions for a Roth IRA. The caveat to opening a Roth is the contribution is not tax deductible. A person may convert a traditional IRA to a Roth IRA, in which case, the converted amount will be taxable in the year of conversion. The determination of which is better, the traditional or Roth IRA, cannot be determined until many years (possibly decades) have passed due to unknown future tax rates.
IRA Eligibility
Anybody can open a Traditional IRA provided they have at least earned income up to the maximum contribution of $6,500 in 2023. Individuals over fifty can contribute an additional $1,000 (“catch-up”) for a total of $7,500. The ability to deduct the IRA contribution depends on the answer to a couple of questions – are you a participant in your employer’s qualified retirement plan? If you are a participant and your income exceeds the limits (see diagram), then no deduction is allowed for an IRA contribution. Still, you can make an “after-tax” contribution, which will not be deductible but can grow tax-deferred.
Pre-tax contributions – deductible when contributions are made, tax deferral on interest, dividends, and growth. Tax is owed when withdrawals occur.
After-Tax Contributions – not deductible when contributions are made, tax deferral on interest, dividends, and growth. Tax is owed when withdrawals occur.
Example of Pre-Tax and After-Tax Contributions:
Taylor, who is single, age 54, participates in his employer’s 401(K) plan. His income is $80,000 per year. Taylor wishes to open an Individual Retirement Account (IRA) and make the maximum contribution for the year. Since his income is below the maximum income level for deducting an IRA contribution ($83K) while participating in his employer’s plan, he is eligible to deduct his IRA contribution.
Taylor’s maximum contribution is $7,500. If Taylor’s income was above $83K, the contribution may be made, but it will not be deductible, thus an after-tax contribution ( A very important concept when discussing back-door Roth IRAs).
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Roth IRA Eligibility
The eligibility for creating a Roth IRA is based on a taxpayer’s adjusted gross income in the year of the contribution. Converting a Traditional IRA to a Roth IRA has no income limitations - anyone can do provided they report the converted amount as taxable income in the year of conversion. For contribution limits, the traditional IRA and Roth IRA contributions are added together to determine limitations.
For example, Teri, age 52, qualifies to contribute either to a tax-deductible IRA contribution or an after-tax Roth IRA. She could split the contribution if she prefers, but she will still be subject to the maximum contribution limit of either 6,500 or $7,500, depending on her age.
The Back Door Roth refers to an individual who converts their after-tax IRA to a Roth IRA. The process is similar to the Mega Back Door Roth, but the amounts converted are derived from the employee's 401(K) plan instead of the individual IRA, which allows for greater contributions than from an individual IRA ($7,500 limit).
Mega Back Door Roth – (Involves 401K plans)
A Mega Back Door Roth involves the backdoor mechanism of rolling over (converting) after-tax contributions in a 401(K) plan to a Roth 401(K) and then rolling to a Roth IRA. The "Mega" term applies because the amount of after-tax contributions allowed in a 401(K) plan is significantly higher than that in a Traditional IRA.
Conditions for Mega to Be Most Effective:
- Maximize 401(K) contributions. Getting an upfront tax deduction and tax deferral on contributions remains the most powerful strategy for accumulating growth. The contribution limit for 2023 is $22,500. For those over age 50, a “catch-up” contribution is allowed for a total limit of employee contributions at $30,000.
- 401(K) plan must allow after-tax contributions or allow in-service withdrawals to an outside custodian.
- Ability to convert 401(K) after-tax contributions to Roth 401K, ultimately rolling over to Roth IRA.
Example
Janet is a highly compensated employee at her company. She maximizes her allowable 401K pre-tax contributions at $30,000 (includes $7,500 “catch-up”). Her company made a matching contribution of $3,500. Her total employee and employer pre-tax contribution is $33,500. The maximum contribution allowed for each employee is $73,500 (pre-tax and after-tax). Janet can contribute an additional $40,000 to her 401K, but the contribution will be after-tax, and she will pay ordinary income taxes on the $40,000. See the diagram below for calculation:
Traditional IRAs (and 401K's) allow for tax deductions on contributions and tax-free growth. However, withdrawals from pre-tax IRAs will be taxed at ordinary income tax rates. Roth investments allow for tax-free growth and tax-free withdrawals, but tax is due upfront on the contributions or conversions to a Roth IRA. So, determining whether a Roth is a good financial idea involves comparing the tax you would pay today on Roth contributions or conversions with the uncertain rates you would pay in the future with traditional IRA distributions.
If you anticipate higher tax rates in the future, either from government fiscal policy or changes in your financial situation, then paying taxes today may be a prudent financial move for you and your family. On the other hand, if your taxable income is projected to decline in the future into lower tax brackets, it may be wise to forego the Roth contributions or conversions because the tax paid today for the principal balance may be higher than what you would pay in the future for withdrawals of the principal amount.
The topic of Roth IRAs can be complex and confusing. Words like "Mega" and "Backdoor" sound intriguing, but until you thoroughly analyze the investment with your financial situation and goals, it may not be as appealing as it sounds. Please visit our website for more information about our services. We offer a no-charge consultation. Please feel free to contact usif you have a question or would like to schedule a no-charge consultation.