Bankrate: What is the difference between a backdoor Roth IRA and a mega backdoor Roth?

14 July 2023

Bob Haegele | Bankrate (TNS)

A Roth IRA is a great way for savers and investors to grow wealth. The advantages include tax-free growth on money withdrawn after age 59 1/2, assuming the account has been open for at least five years.

But high earners often can’t contribute to a Roth IRA. If your modified adjusted gross income (MAGI) is more than $153,000 in tax year 2023 ($228,000 if married, filing jointly), you can’t contribute to a Roth IRA at all.

This situation gave rise to the backdoor Roth and the mega backdoor Roth. They sound similar, but there are many differences between the two strategies. If you’re a high earner, one of them might be worth pursuing.

What is a backdoor Roth IRA?

A backdoor Roth IRA is fairly straightforward. If you make too much to contribute to a Roth IRA, you contribute to a traditional IRA instead. While you can only contribute up to $6,500 to an IRA in 2023 ($7,500 for those 50 and over), there is no specific conversion limit.

Suppose you’ve been contributing to a traditional IRA for years. You could theoretically convert several years of contribution at once, moving them from traditional to Roth. However, if you have pre-tax money in your traditional IRA, you may not be able to move it into a Roth account. This is due to the IRS’s pro-rata rule. And even if this doesn’t apply, the conversion could be taxable.

What is a mega backdoor Roth?

The backdoor Roth is a good way to grow wealth without paying taxes on earnings, but the pro-rata rule makes it infeasible for some. In that case, the mega backdoor Roth might be a viable alternative.

The mega backdoor Roth works a little differently. With this strategy, you usually contribute the maximum amount to a 401(k), which is $22,500 in 2023 ($30,000 for those 50 and over). Then, you contribute an additional $43,500 in after-tax dollars to your 401(k), assuming no employer match. Finally, you convert the money to a mega backdoor Roth, which can be either a Roth IRA or Roth 401(k), if your plan allows.

The reason for the $43,500 limit is this plus either $22,500 or $30,000 puts you at the maximum total contribution for the year. You must deduct that from the $43,500 if your employer offers matching contributions.

To pursue this strategy, your employer’s plan must allow after-tax contributions to their 401(k). It must also allow either in-service distributions or let you move money from an after-tax part of your plan to the Roth 401(k) part of your plan.

While this strategy is more complex than the backdoor Roth, it can be worth it for those who earn a lot — and whose employers’ plans have the characteristics necessary to enable the mega backdoor Roth.

Mega backdoor Roth vs backdoor Roth IRA

Both strategies can give your savings a boost, but each has pros and cons:

Backdoor Roth pros

—Get around income limits: A backdoor Roth allows you to contribute to a Roth IRA, even if your income would normally preclude you from doing so.

—Tax benefits: Money in a Roth IRA can be withdrawn tax-free in retirement, assuming the account has been open for five years.

—No required minimum distributions (RMDs): There are no RMDs for Roth IRAs, so you can withdraw the money whenever you want.

Backdoor Roth cons

—Tax consequences: There could be state, local or federal taxes that apply to backdoor Roth conversions.

—Higher income brackets: Because backdoor Roth conversions mean moving money from a pre-tax bucket to an after-tax bucket, it could move you into a higher income tax bracket.

—Five-year rule: Money must generally sit in a Roth IRA for at least five years before you can withdraw it penalty- and tax-free.

Mega backdoor Roth pros

—Larger contributions: This strategy lets you contribute much more than normal into a Roth IRA (up to $43,500 in 2023).

—Tax-free growth and withdrawals: Once the money is in the Roth account, it can be withdrawn tax-free in retirement.

—Minimizes taxes: If you roll funds into a Roth plan soon after the contribution, you can minimize the taxes you would otherwise pay on gains.

Mega backdoor Roth cons

—Limited availability: To access this strategy, your employer’s plan must allow after-tax contributions to a 401(k), plus either in-service distributions or conversions.

—Tax implications: You may still owe taxes on the money you convert from a traditional 401(k) to a Roth account.

—Five-year rule: Much like the backdoor Roth, money generally must sit in a Roth account for at least five years before you can withdraw it penalty- and tax-free.

Bottom line

The backdoor Roth and the mega backdoor Roth are both viable strategies for getting around the typical income limits of a Roth IRA. The backdoor Roth IRA is best for converting money from a traditional account to a Roth. Meanwhile, the mega backdoor Roth is most suitable for high earners who want to contribute more than the typical contribution limit. Consider working with a financial adviser before committing to one or the other.

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