Mega Backdoor Roth takes traditional 401(k) investment to the next level for high net worth individuals. If you qualify, you can save an additional $41,500 for your Roth IRA retirement. However, this is difficult and mistakes can be costly.
While the megaoption is similar to the Roth IRA backdoor, they are two different accounts. Even though they are both designed for high net worth individuals to convert a traditional IRA fund into a Roth fund, they operate in different ways.
The backdoor option was designed for high net worth individuals who could make regular contributions to Roth using deferred taxes. In contrast, the Roth IRA mega backdoor was designed for post-tax 401(k) deductions to convert to a Roth IRA.
You can name a variant of the mega backdoor mega as it offers a larger after-tax contribution to a Roth IRA. However, this is not for everyone. The choice comes with some restrictions. However, for some it works great. So it’s worth knowing about it. In this article, we will talk about the basic rules of Roth’s Mega Backdoor to see how it works in 2022.
What is an Individual Retirement Account (IRA)?
An Individual Retirement Account (IRA) is a savings and investment account with tax benefits. The traditional IRA uses pre-tax dollars, while the Roth IRA uses after-tax dollars. As a result, they both have tax savings, either now or later.
You can open an IRA through a bank, investment brokerage, or employer. Through IRA employers: 401k, Roth 401k, 403b, Roth 403b, Thrift Savings Plan, or SEP (Simplified Employee Pension).
IRAs are used to buy stocks, bonds, mutual funds, due date funds, exchange-traded funds, and more. Employer-sponsored plans may have limited choices. However, many offer employer-appropriate contributions.
Because of the tax benefits, IRAs are designed for retirement. They incur a 10% early withdrawal penalty, but this can be waived in situations such as financial hardship, first-time homebuyers, certain education expenses. Traditional IRA accounts will have to pay taxes on withdrawals in addition to the penalty.
Roth IRA vs Traditional IRA
A Roth IRA is an Individual Retirement Account (IRA) funded with after-tax dollars. This allows funds to grow over time without paying income taxes. In other words, withdrawals are tax-free at the time of retirement, which leaves more money in the pockets of retirees.
Unfortunately, high net worth individuals cannot directly contribute to a Roth IRA. Maximum contributions are limited to individuals who earn less than $129,000 (single) and $204,000 (married). Thereafter, contributions are phased out for individuals earning more than $144,000 (single) and $214,000 (married, filing jointly).
A traditional IRA offers an upfront contribution tax credit with taxable retirement exemptions. However, it does not come with income limits.
Both types of IRAs have contribution limits. For 2022, the total annual contribution cap is $6,000 for those under 50 and $7,000 for those aged 50 and over.
While both types of IRAs have the same contribution limits, high-net-worth individuals lose out on the tax-free growth that Roth IRAs provide. However, they have another option: the Roth IRA backdoor.
Backdoor Roth IRA
The Roth IRA backdoor allows high net worth individuals to transfer funds from a traditional IRA to a Roth IRA. Individuals must pay taxes on the money they transfer (because they did not pay taxes on the initial deposit) and can transfer up to a maximum contribution limit of $6,000 for those under 50 ($7,000 for those over 50). ).
Here are the basic principles to follow:
- No other pre-tax IRAs. Make sure you don’t already have a large IRA account, including a 401(k) from a previous employer.
- Contribute to the traditional IRA. Create a traditional IRA. Pay deferred income tax up to $6,000 ($7,000 for those aged 50 and over).
- Convert your traditional IRA to a Roth IRA. Unlike contributions, conversions have no revenue limits. You can transfer up to $7,000 (depending on your age) from your Traditional IRA to a Roth IRA in a given calendar year.
It is important to note that traditional IRA contributions use deferred income tax. If you want to make after-tax deductions, check out the Roth IRA mega backdoor.
Mega Backdoor Roth IRA
The Mega Backdoor Roth IRA allows you to increase your investment. After maximizing your traditional 401(k) contributions ($19,500 for under 50s, $25,000 for over 50s), you can contribute after taxes up to the maximum annual contribution (employee and employer) if your the employer’s plan allows it. That’s an additional $41,500 in the Roth IRA with after-tax dollars ($48,000 for those over 50).
The Mega Backdoor Roth IRA is tricky. However, here are the basic principles:
- Your company must offer an after-tax contribution option on your 401(k) form.
- Your company must allow the 401(k) conversion to the Roth IRA.
- You should make the most of your traditional 401(k) contributions.
- You have the funds to deposit additional money on your 401(k) form.
Benefits of the Roth IRA Megabackdoor
The Mega Backdoor Roth IRA has benefits for the right person. Here are some of them:
- This can quickly increase the overall retirement savings rate. After maximizing their annual contribution limits, people investing in their 401(k) are saving over $20,000 a year for retirement. Together, this leads to rapid growth. With a 10% annual return, a $25,000 monthly investment can grow to over $1.9 million in 5 years.
- The Mega Backdoor Roth IRA allows for a significant increase in deferred tax if done right. The result is significant tax savings.
Cons of the Roth IRA Megabackdoor
The Mega Backdoor option is not without flaws. Take a look at this list for more details:
- It is not easy to contribute beyond deferred tax contributions. The maximum contribution of $20,500 is $1,708 per month (the maximum contribution increases by $6,500 for those aged 50 and over). This is a high level of savings. To take advantage of the Roth IRA mega backdoor, you must save at a higher rate.
- Not all employers offer Rollover Roth IRA options. Despite some incredible benefits, not everyone can qualify for a Roth IRA mega backdoor because of their employer.
- The rules may change. Lawmakers are talking about changing deposit and withdrawal limits for high-paying Roth IRA retirement accounts. It’s worth following if you’re considering this option.
- The withdrawal of funds is governed by the proportionality rule. The proportionality rule states that your outputs should be equal to the ratio of your contributions. So, in some cases, you may end up paying more taxes than if you had invested in a Roth IRA from the start.
The IRS treats your IRA as one big bank. Thus, the percentage of tax-free distribution is equal to the total amount of after-tax contributions divided by the entire balance of the IRA.
For example, you have $100,000 in a traditional tax-deferred IRA and $50,000 in a rollover Roth IRA. The IRS will assume that your payments were made from both accounts at the rate of your initial contributions. Therefore, 50% of the $50,000 ($25,000) in your rollover Roth IRA will be tax-free and 50% ($25,000) will be tax-deductible.
It can be difficult to determine your tax bracket using the Roth IRA mega backdoor. You may need to seek the help of a financial advisor and a tax advisor.
Who is eligible for Mega Backdoor Roth?
Individuals investing in a Mega Backdoor Roth IRA earn over $144,000 per year (Maximum income for a single Roth IRA: $214,000 married jointly). They must have sufficient income to pay their expenses by investing more than $20,500 in their traditional employer-sponsored 401(k) plan. In addition, they must work for a company that allows after-tax deductions and Roth renewals.
Mega Backdoor Roth Alternatives
Mega Backdoor Roth is not for everyone. This is fine. With strong money habits, anyone can become a millionaire. When looking for a job with a higher income, you can:
- Improve your financial literacy
- Gather your finances
- start budget
- Learn to pay yourself first
- Cost reduction
- Minimize bad debt
When you’re ready to start investing, the following options may come in handy:
- Traditional 401(k) or Roth 401(k) through your employer
- Thrift Savings or SEPs through eligible employers
- Health savings account
- Traditional or Roth IRA with online investment broker
- Robo-investments with automatic savings
- Taxable brokerage account
The Mega Backdoor Roth IRA is a mega savings option for high net worth individuals. This opens the door to high savings rates and significant tax savings over time.
However, this option is difficult. People will need to weigh the pros and cons or consider seeking the help of a financial advisor or tax advisor.
Building wealth takes time. There are alternatives to the Roth mega backdoor. So, invest early and invest often by averaging dollar value.
This article originally appeared on Wealth of Geeks.