Individuals with high incomes may encounter what is often termed a “quality problem.”
This issue arises when they earn such substantial amounts that their capacity to save exceeds the limits of traditional retirement accounts. The current contribution caps are $23,000 for a 401(k) and $7,000 for IRAs, which might not fully accommodate their potential for retirement savings. As a result, these individuals might find themselves with so much in savings that they need to open a taxable brokerage account merely to invest it, which is indeed a favorable dilemma.
However, high earners might have a chance to further increase their savings in tax-advantaged retirement accounts. An obscure strategy could potentially allow them to save an additional $46,000 in their 401(k) or Roth IRA by 2024. This strategy is known as the mega backdoor Roth.
This option isn’t universally available, and it necessitates the ability to save substantial sums to truly benefit from it. Nevertheless, it could unlock enhanced savings opportunities for those with high earnings. Here’s what you need to understand.
Accessing the Mega Backdoor Roth
For those whose income exceeds the thresholds for directly contributing to a Roth IRA, the backdoor Roth IRA might already be a familiar concept. The mega backdoor Roth operates similarly but involves your 401(k) and a few specific regulations.
To quickly summarize the regular backdoor Roth IRA: if you’re unable to contribute directly to a Roth IRA due to income limitations, you can still make a non-deductible contribution to a traditional IRA. Although this doesn’t provide an immediate tax benefit, you can quickly convert these funds into a Roth IRA, which essentially mirrors a direct Roth IRA contribution.
With the mega backdoor Roth, you can leverage a lesser-known IRS rule concerning the total contribution limits to a 401(k) or other defined contribution retirement plans. These total contributions encompass regular payroll deductions, employer matches, and a unique type of employee contribution called (non-Roth) after-tax contributions. For 2024, this total contribution limit is set at $69,000. Those aged 50 and above can also add a $7,500 catch-up contribution, raising the total limit to $76,500.
Not every 401(k) plan permits additional after-tax contributions, which serves as the initial challenge in implementing the mega-backdoor strategy. Carefully review your plan or consult your HR department to determine if it’s allowed.
If your plan does permit extra after-tax contributions, you must also have the ability to convert those funds into a Roth account. This could be a Roth account within the 401(k) plan or a separate Roth IRA. Some plans might allow one option but not the other.
Ideally, a separate Roth IRA is preferable, given its broader investment choices and the potential to avoid fees typically associated with 401(k) plans. To execute a Roth IRA conversion, your plan must support “in-service withdrawals.” Check for this provision within your plan documents or confirm with HR.
In total, if you can utilize the mega backdoor Roth, you might add as much as $46,000 to your retirement accounts in 2024, significantly contributing to a more secure retirement.
Advantages of the Mega Backdoor Roth for High Earners
Without the mega backdoor Roth, excess retirement savings would need to go into a regular taxable brokerage account.
For retirement savings, a Roth account is generally preferable to a taxable account. The primary advantage is that you won’t incur taxes on capital gains from investments in the Roth account. Additionally, you won’t pay taxes on any annual dividends or interest income, which could otherwise increase your tax liability while employed.
Holding savings in a Roth retirement account might also aid your child in qualifying for more financial aid for college. Assets in retirement accounts don’t count on the FAFSA, while those in taxable brokerage accounts do, potentially easing the financial burden of college expenses on you or your child.
However, the mega backdoor Roth does have some downsides. Retirement accounts are designed for long-term savings, meaning you can’t access earnings without penalty until reaching age 59½. This restriction might pose a challenge for high earners who save a substantial portion of their income and plan to retire early.
You may withdraw contributions from a Roth IRA without penalties before age 59½, but early withdrawal of earnings incurs a 10% penalty and income tax on the amount withdrawn.
For those with a Roth 401(k), be aware that early withdrawals are prorated between contributions and earnings, ensuring some penalty unless the account is first rolled over into a Roth IRA upon early retirement. In such cases, remember the five-year rule, which mandates having a Roth account open for five years before tax-free withdrawals.
If you have access to the mega backdoor Roth and the capacity to fund it, it often makes substantial financial sense to take advantage of it. The tax benefits and protections it offers can hasten your retirement timeline or provide greater financial security when you choose to retire.
The $22,924 Social Security Bonus Most Retirees Overlook
Like many Americans, you might be behind on your retirement savings. However, several lesser-known “Social Security secrets” could significantly enhance your retirement income. For instance, one straightforward trick could boost your annual income by as much as $22,924! Understanding how to maximize your Social Security benefits might allow you to retire with confidence and peace of mind. Click here to learn more about these strategies.
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