The Mega Roth IRA Backdoor is an extreme strategy that might be available to you, assuming you have a little luck and the proper 401(k) plan.
Some bloggers have discussed the inherent unfairness of the Roth IRA‘s contributions – namely, being capped at $125,000 for a single filer and $183,000 for a joint filer in 2012. Other have discussed the backdoor IRA – building on a 2010 rule change which allowed people of any income to convert IRAs (and other eligible accounts) to Roth IRAs.
We’re going to bypass both of those and talk about the mega Roth IRA BAckdoor… you may be able to contribute over $30,000 to your Roth IRA – with the only requirement being that you have access to a 401(k) with certain features. Read on…
How 401(k) Limits Work
In 2016, an employee can contribute $18,000 as an elective deferral to a 401(k). However, 2016 contribution limits are actually capped at $53,000. That includes the more esoteric employer matching contributions and employee after-tax contributions.
The key to this method is that last piece of the puzzle, employee after tax contributions. Not all 401(k) plans allow this little twist on the traditional 401(k), but if yours does, it usually works something like this:
- Contribute the maximum elective deferral ($18,000)
- Receiving matching funds from employer (Say, up to 6% of $100,000 or $6,000)
- Contribute the rest of the $53,000 in after-tax contributions ($29,000)
- Move onto the next step (obviously, don’t proceed if the next rule doesn’t apply)
Now What’s the Secret Step?
The key to the whole strategy is a wonky little feature of 401(k) accounts known as “in-service withdrawals”.
All but the most liberal of 401(k)s will lock down the money that you contribute on the elective deferral side, but a fair amount of accounts will allow in-service withdrawals of certain types of money – usually rollovers from previous employers and (more importantly) after tax contributions.
If your employer offers both of those features (or, alternatively, some other types of rollovers) you’re well on your way. Usually, however, in-service withdrawals are limited over a certain time frame – and the most common limit is one per year. With that information in hand, you’re ready for the final step.
Step 3 – Profit From the Mega Roth IRA Backdoor!
Now, noting how often you can perform in-service withdrawals, it’s time to take action. Because of tax changes in 2010, you can roll over withdrawals from a 401(k) directly into a Roth IRA. Note that you contributed your after tax funds… well… after tax, so you don’t have to pay income taxes on that part of the withdrawal. On the earnings? You do, but note you can take a tax loss if you lost money in the meantime. So follow me through:
$29,000 in rollovers
+ $5,000 in regular Roth IRA contributions
$34,000 in Roth IRA contributions in 2016
Now, I make no claims that it’s worth getting a Roth IRA in your situation, and go talk to a financial adviser before you attempt this maneuver. You’ll also need to pour over your company documents and probably verify with someone in the administration of your 401(k) plan that the Mega Roth IRA Backdoor is doable. Also check out Fairmark.com’s article on the topic.
So, there you have it – I spelled out a way for even high earners to contribute absurd amount of cash to a tax-free account (at the point of withdrawal, anyway). As Judge Learned Hand once famously stated, “Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes. ”
Go avoid taxes in a completely legal way with the Mega Backdoor Roth IRA, you patriot!