For individuals who fall into the category of higher earners and are seeking ways to maximize tax-free retirement savings, there is a potential strategy that often goes unnoticed. While Roth individual retirement accounts are known for their tax-free growth and other advantages, there are income limits that prevent some investors from making direct contributions. However, a lesser-known method called mega backdoor Roth conversions can provide a solution by allowing individuals to circumvent these restrictions and contribute to a Roth account.
A mega backdoor Roth conversion involves shifting after-tax 401(k) contributions into a Roth account. This approach can be especially beneficial for individuals who have already maximized other tax-advantaged options and have excess funds that would otherwise be invested in a brokerage account, subjecting them to yearly taxes on capital gains and dividend distributions. According to certified financial planner Brian Schmehil, managing director of wealth management at The Mather Group in Chicago, this strategy is a “no-brainer” for high earners who do not require the cash for other financial goals.
For the year 2024, the adjusted gross income limits for Roth IRA contributions stand at $161,000 for single filers and $240,000 for married couples filing jointly. On the other hand, the pretax or Roth 401(k) deferral limit for 2024 is set at $23,000, with an additional $7,500 for individuals aged 50 and above. The maximum 401(k) limit for the same year, including deferrals, employer matches, profit sharing, and other deposits, is $69,000. While this strategy can offer significant advantages, it should be noted that not all 401(k) plans permit mega backdoor Roth conversions.
Factors to Consider
Before proceeding with after-tax contributions and conversions, it is crucial to review your 401(k) plan documents thoroughly to understand any specific features and limitations. While you will not owe taxes on converted after-tax contributions, there may be taxes levied on the growth of these funds. One key distinction between Roth and after-tax 401(k) contributions lies in the tax treatment of growth. While Roth contributions experience tax-free growth, after-tax investments are tax-deferred, meaning that regular income taxes will apply to withdrawals during retirement.
To minimize upfront taxes on conversions, experts recommend converting after-tax funds regularly. By implementing this strategy effectively, individuals can potentially avoid taxation on all growth, as highlighted by CFP Dan Galli, owner of Daniel J. Galli & Associates in Norwell, Massachusetts. While the process may require careful planning and adherence to tax regulations, the long-term benefits of tax-free growth in retirement can be significant for high-income earners utilizing the mega backdoor Roth conversion strategy.
The mega backdoor Roth conversion represents a valuable tool for high earners seeking to maximize tax-free retirement savings beyond traditional limits. By leveraging after-tax 401(k) contributions and Roth conversions, individuals can unlock additional opportunities for growth and tax savings in the long term. It is essential to consult with a financial advisor or tax professional to evaluate your specific circumstances and determine whether this strategy aligns with your financial goals and retirement plans.