In today's episode Nicholas Olesen, CFP®, CPWA® shares one of the best tools for retirement savings, the Mega Backdoor IRA.
The team at Kathmere has found this to be a unique and not well known way to save into a Roth IRA even if you are over the income limit. In this episode he covers:
How the Mega Backdoor Roth IRA contribution works
The biggest mistakes people make when trying to do it
How the pro rata rule can void the benefit of a traditional Roth IRA conversion
Flowchart we have used to help navigate the complexities of the Mega Backdoor Roth IRA contribution and also Roth IRA conversions
Please send us feedback and any topic or questions you would like us to cover. Email us at: firstname.lastname@example.org
Flow charts referenced in the podcast:
Hi, thanks for tuning into A Wealth of Advice. My name is Nick Olesen, Director of Private Wealth here at Kathmere Capital today, we're going to talk about the Roth IRA. But not the simple, "hey, how do I put money in a Roth IRA?" That that's an easy one. What we're going to talk about is something called a backdoor Roth IRA, and specifically a mega backdoor Roth IRA.
I feel like I should have some sound effects here for that, but that's not what we do around here.
So when we talk about a Roth IRA, let's start with the basics. A Roth IRA is an investment vehicle that we use for retirement, you put money into a Roth IRA from an after tax contribution, meaning you've already paid taxes on it.
And then that money grows tax-free. So that's the biggest benefit. Think of it this way you put $10,000 into it or let's, let's actually go with contribution limits. You put about $6,000 into it when you're 20 years old, you work a summer job, and then all of a sudden you're 65 years old and that money has grown to be, you know, tens of thousands of dollars and it's all tax-free. So you just really gotten to get great bang for your buck there.
What the problem is with a Roth IRA from our standpoint is you can not contribute to it if you've made over a certain income level. And as an individual single filer, it's $125,000. And as a married couple, it's about $200,000. It's 196 to 206, you completely phase out. So for a lot of our clients, it's not an option to contribute to a Roth IRA. And so there's other ways that we do it. And so one of the ways that we have looked at this and, and made the contribution into a Roth IRA for those that are above the income limit, is done something called a backdoor Roth IRA contribution.
The way it works is you take money and you put it into a traditional IRA, but you do not take the tax deduction. You do as an after-tax contribution to your IRA. Do not take the deduction in that calendar year. And then the next day convert it to a Roth IRA. It's actually a way you can get money into the Roth IRA, even though you're above the tax limit.
Now, the way they've made this so it's not just everybody can do it is, there is something called the prorata rule, and this is something a lot of people don't pay attention to. What it is, is, is the IRS says that if you have IRAs, any type of IRA account, a SEP IRA account, traditional IRA account, not a 401k. So this is specific, just an IRA account. You actually have to take your entire account balance across the board. And then look at this small contribution, you just made the $6,000 contribution. And let's say you have a $600,000 IRA account. You can actually only get this tax-free conversion on the percent of the after tax portion compared to pre-tax.
So in this situation, it's basically only 1% is going to be tax-free. The rest of it's going to be a Roth IRA conversion that is fully taxed. And for clients that we're doing this for, it's usually because they're in a very high tax bracket. And so we don't want to convert money that is pre-tax dollars and then pay taxes at a high income rate.
So for a lot of clients, it really doesn't work. But for those that it does, it's a fantastic tool.
So then what is the mega backdoor Roth IRA? Well, when you look at the mega backdoor Roth IRA, the beauty of it is it's actually a way you can contribute a lot more than just $6,000 after tax and then immediately convert it.
And the reason you avoid the prorata rule is we're actually doing it through an employer plan, a 401k type of plan. What we look at and you need to look at summary plan documents, and I'm going to go high level here, and then you do need to explore this more or talk to somebody like myself who can explore this for you to find this out. And what we look at is your summary plan document inside your plan, and we see if it allows you to make after tax contributions. We also look to see, does it allow you to do immediate conversions? What's called an in-plan Roth conversion to convert that to a Roth IRA. Or do you have to do it through a distribution and then conversion?
And all different plans are out there, so we are very fortunate we worked a lot of claims at Merck and they do allow an in-service conversion while you're, we're still employed there. So it's a whole, a fantastic tool that we use for them.
The way this works is we are allowed to contribute, if you know the regulations or, you know, kind of the numbers here, I'm going to go through them a little fast. You can con contribute $19,500 pre-tax into your 401k or into the Roth portion of your 401k. If you're over 50, you can contribute $26,000. Once you've gotten over that limit, typically it cuts you off. You can't save any more into it. But a lot of plans have something called a spillover or where you can do an after tax contribution to it. So if they allow you to do that, if then you've also passed some testing on it to allow these additional contributions. You can actually, between you and your employer, have a total contribution into the plan of $58,000.
It's a lot more than what most people are used to of that $19,500 or $26,000. Even with a fantastic company match, say it's dollar for dollar, and you're over 50 and it's all the way up to your full contribution, that still means you're only getting $52,000 into the plan. Look, that would be a fantastic company match, but most are not that high.
So for most people, let's say that you're under the age of 50, you contribute $19,500 into your plan. Your company matches another $10,000. You've only put $29,500 into the plan. So you have a, quite a large amount that you can contribute more into your 401k plan.
So, how do you do it? You are then allowed to make an after tax contribution for it. This excludes catch-up contributions and everything else. This is just you and your employees contributions up to the 58,000. So for those over 50, you do have this additional call it $6,500. You're allowed to contribute on top of this number. We're talking about. And then you make this contribution after tax into your plan, if it allows that. Immediately, the next year, the current year, whenever your plan allows you to do this distribution, you take those funds out of your 401k plan. If it's inside your plan, you do an in plan Roth conversion, makes it very easy. It just automatically switches to a Roth 401k plan inside your plan.
Most plans that we work with do need to do a distribution. So you're actually going to request a distribution, while you're employed and make sure it does not turn off any matches or anything else like that. So you need to be very mindful of what you're doing here. And then you take that money that was after tax and you directly put it into a Roth IRA. Again, do not put it into an IRA and then put it into a Roth.
You've then voided out this entire trick. So would you want to do, as you put that money directly into a Roth IRA, make sure the check is made payable to the Roth IRA. Make sure you have an account already set up, the whole nine. And then that contribution will show up when IRS gets their 1099R and you get the distribution notice, showing that that it is a non taxable distribution. It was after tax money going in and therefore you've been able to make a backdoor Roth.
So how much can you put in? Well, let's just run through those numbers again. Let's say that it was $19,500. You contributed your employer matched $10,000 there. You're putting almost $20,000 into the plan that is then being converted immediately into a Roth IRA. So you're making a $20,000 contribution in a Roth IRA in one calendar year, more than you can do in the traditional sense. So that's why we call this mega backdoor Roth IRA. It's kind of a fun term. I got no sound effects here.
But when you look at that, that then becomes your Roth IRA. It is immediately upon like a Roth IRA. It starts the five-year window of how long you have to have it in a Roth IRA before it qualifies for the tax free distributions down the road. But you do have to keep it separate, you do have to keep it in this Roth. IRA, do not bring it back in. Don't change it. Don't think of it as a, as an IRA, don't put it in an IRA and then a Roth it's very specific. You have to go from your 401k into the Roth IRA.
If you do get tripped up along the way. You can reverse this and it's a lot of paperwork, but you can get it done. So when we look at it, that's the, this mega backdoor Roth IRA.
It's a fantastic tool. A lot of companies do allow this and a lot more companies are offering this as we've seen through summary plan documents. So if your employer does, take a look at the summary plan document to find out, if not read through it, ask your HR, figure that out because it's a fantastic tool.
While we're on the subject of Roth IRAs I thought it would also be smart at this time of year to talk about Roth conversions. Again, we touched on it slightly in there on this prorata rule side of it. But one of the things that we get a question a lot of times, especially for our retired clients is, "what's the most tax advantage way of taking distributions and then also passing it onto my family" and estate planning and you name it.
So Roth IRAs has come up a lot in this because once the dollar is in there, you can just allow it to continue to grow tax-free. You don't have the required minimum distribution that you have to take out of it if it's your Roth IRA. And so really what we're trying to do is figure out how to get money in a Roth IRA.
Because Roth IRAs, were not in existence a couple decades ago. This is a new vehicle. It's a new tool to use. And in 2000, what was this? 2014, I'm dating myself here 2014, maybe 2012. I don't remember. They changed, I probably should have looked this up ahead of time, they changed the regulation saying that no matter your income level, you can convert a Roth IRA in, or you can convert an IRA to a Roth IRA.
Before that was a hundred thousand dollars limit is if you made over that, you could not do this conversion. And so they changed the regulation. I think it was 2012 when they changed it over to allow you to do that. And they took away the income limit. And so you just get to choose. And so one of the things that we've put together is a couple different flow charts, one is on this mega backdoor Roth IRA, how to do it and things like that. And the other one is this, "should I do a Roth conversion?" And so when we look at it, there's a lot of questions through here. I'm just going to touch on kind of some of the high-level ones, which is, Hey, is it, is it an IRA that you have great if you convert it now what's the downside, what's the upside to it.
And what the game that we're playing in, both the backdoor Roth contribution and also this Roth conversion, but, but really in the Roth conversion is what we call tax arbitrage. We're trying to take advantage of a time in your life where you believe you're going to be at a lower tax bracket than you are in the future. Or in the future, you're going to be a lower tax bracket. So you won't take as many as you can today.
That's what drives the discussion around doing a Roth conversion. It also drives the conversation and our analysis behind where to contribute dollars in different savings accounts. Should you use traditional 401k or a Roth 401k, is after tax accounts, 529s. You name it. Should you use them at all? Is, is tax that we're talking about here.
When you look at the Roth conversion conversation, it really comes down to this tax rate. Do you expect to be subject to the same or a lower income tax during most of your retirement or at some point in the future, if you do then do not do the conversion, but if you don't, if you think, "you know what, they might change the tax code on us."
This is April of 2021, and so, we're, we're hearing that they might change the tax code. If I'm in that higher bracket, I need to start doing this now. But, if you think that maybe there's a chance I'm either going to have a low-income year one year or my retirement. I'm gonna retire early and have this big gap in income when social security and pensions and so on and so forth turned on so I will have a much lower tax bracket. Well, then you want to wait.
But that's the starting point.
If you think, no, I'm not going to have a lower tax bracket than I have one today. Then the question comes down to, do you have money outside of this iRA account that you can pay the tax bill with? Because if you pay it through the IRA distribution, you've actually just kind of given yourself a cut, you've already taken off the benefit of the Roth. You really want to take every dollar that was in that IRA and put it to the Roth IRA and pay the tax on the outside.
That one question on having cash outside of that is really important because if we have to take the hit of 20 or 25% to pay your tax bill today, it might not make sense long-term, depending on longevity, depending on everything else on return to actually take that tax it today, just to convert it for tax-free growth. You're getting 75 cents working for you versus keeping a hundred dollars working in there.
So again, you do have to do the analysis work on there. It just might not make sense.
The other thing that we look at when we talk about Roth conversions is Required Minimum Distributions. Again, to kind of fly through this, because this is something that we can dive into in the future, but required minimum distributions are an IRS requirement for you to take a distribution from a qualified retirement account, starting at the age of 72 now. It used to be 70 and a half. It's now 72 moving forward.
When you look at it, that it's a percentage that you have to take out of your account. So one of the benefits of a Roth IRA is you do not have to take a Required minimum distribution. And so for a lot of clients that not having to take a Required minimum Distribution, looking at a low tax rate today versus where they think they'll be in the future.
And then one of the other big ones is that for estate planning tools, you know, after you pass away, the income is a tax-free distribution to your beneficiaries. It's enormous. Now they still are subject to a 10 year rule. So they do have to take these distributions, but being able to convert and put it in a Roth IRA and then allow your family to receive that tax-free in the future versus who knows what the tax rate's going to be, or who knows where they're going to be in life when they receive that and they only have 10 years to take the money out of an IRA or a Roth IRA. A lot of times it makes sense to accelerate these conversions and put money in a Roth IRA, so therefore your family longevity, long-term benefits tax wise. You might not, but if the total tax bill is less over the lifetime of this account, it can be better.
The other side I touched on, and this is when we talk about conversions is, and I said it earlier, is it starts the five-year window on your contribution into a Roth IRA. So what this is is you start a five-year window, you cannot take a distribution, above what you've contributed from a Roth IRA without getting hit with taxes or penalties, if you've had not owned it for more than five years.
This is very important when you're looking at all, I'm going to convert a Roth and then I'm gonna start taking distributions the next year back to the bus stop. You might have to actually pay some taxes on it if you go above and beyond what your contribution was to it. So again, be mindful of that.
The last point that I'll touch on here is for retired clients, or those right around age 65 or above. If you are, are getting Medicare, and you don't want to increase your income, which would then increase the amount you pay for Medicare. A Roth IRA conversion might not be the best option for you.
You know there are bands, as I'm sure that anyone who's on Medicare knows and has looked at it once you hit a certain threshold, you can be a dollar over the threshold and all of a sudden your cost for your insurance can double. And so you really have to be mindful when you're doing these conversions not to trip up and all of a sudden hit some income-based program that you're now not eligible for, or a lower premium, or you name it.
So just be mindful of that, just one last tip on there.
So I think, I think that covered it as far as kind of this, this mega backdoor Roth IRA, and then also just Roth IRA conversions in general, we're going to do a couple more tax themed podcasts coming up just as this is tax season. And so we thought it'd be great to come out with this. And then we'll do a couple more after this.
We also are going to be talking about Bitcoin coming up. So look out for that one. We have that podcast on the queue have, have a great guest coming on for that.
And then we're also going to be touching on in, about two months from now, we have a fantastic guest, a professor from over the pond, as they say to talk about modern monetary theory. Talk about really kind of what is going on in the economy. What is all of this quote, unquote money printing doing? What, what is the long-term effect of, of this? So look forward to those podcasts. We'll continue to talk about them and let you guys know when they're coming up, but.
Thank you again for your time. We always really appreciate it. Hope you guys are finding these very beneficial and please do reach out with questions.
We love getting questions that helps us with knowing what topics you guys enjoy. Thanks. Have a great day.