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How Mega Backdoor Roth IRAs Work

How Mega Backdoor Roth IRAs Work
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Are you interested in a little-known strategy that could help you save up to $43,500 into a Roth IRA every year? This method is known as the Mega Backdoor Roth IRA and it can be a game-changer for individuals with high income. However, it can be complex and not suitable for everyone.

The Power of a Roth IRA

Roth IRAs are incredible accounts for building long-term wealth. You contribute after-tax money, and your investments grow tax-deferred, meaning there’s no capital gains tax, taxes on dividends or interest. And best of all, after you reach age 59.5, you can withdraw the funds tax-free. Your Roth IRA could grow from $10,000 to $1,000,000 and it would be completely tax-free!

Despite the allure of the Roth IRA, contributing meaningfully to it can be challenging due to income restrictions. This is where the Mega Backdoor Roth IRA workaround comes by allowing those not eligible for a Roth IRA to not only still make contributions, but to make much larger contributions than the normal Roth IRA limit.

Roth IRA Income Limits For 2023

To be eligible for a Roth IRA, your Modified Adjusted Gross Income (MAGI) and tax filing status determine the amount you can contribute.

  • If you’re single, your MAGI needs to be under $138,000 for a full contribution, which gradually reduces and becomes ineligible once you reach $153,000.
  • For joint filers, the phaseout range starts at $218,000 and ends at $228,000.
Tax Filing StatusFull ContributionPartial ContributionIneligible
Single< $138,000$138,000 – $153,000> $153,000
Married< $218,000$218,000 – $228,000>$228,000

With the contribution limit set at $6,500 annually or up to $7,500 for those over 50, high-income earners may feel a Roth IRA isn’t a viable savings option. However, this is where the Mega Backdoor Roth IRA strategy can prove beneficial.

Navigating the 401(k) Contribution Limits

In 2023, the 401(k) contribution limit rose to $22,500 with an additional catch-up contribution of $7,500 for those over age 50. That is the IRS’s limit on how much you can “defer” for income tax purposes. This means you can “defer” $22,500 of income into your 401(k), resulting in an equivalent reduction in your taxable income.

You may not realize that the IRS has another limit for 401(k) plans based on the total dollars that can go into a plan, which is much higher. In 2023 the total dollar limit is $66,000 a year for those under 50 and $73,500 for those over 50. This limit is inclusive of any employer-matching contributions.

Screenshot 2023 05 19 at 12.10.24 PM

For example, if you are 45 years old and max out your traditional 401(k) with a tax-deferred contribution of $22,500, and your employer contributes an $8,000 match, you are at a combined total of $30,500. That leaves you with $35,500 remaining until you reach your total dollar limit of $66,000. You can’t contribute more to either a traditional or the Roth version of your 401(k) because you have already reached the limit for those. You can, however, contribute what is known as “after-tax” money up to the remaining limit. 

Why would you contribute after-tax money

It’s not about the after-tax contributions, it is about what you can do with these funds. If done correctly, this can be one of the most powerful financial planning strategies to build long-term tax-free wealth.

When your 401(k) plan allows it, immediately after contributing these after-tax dollars ($35,500 in this example), you can convert these funds into the Roth 401(k) part of your plan or roll them over into a Roth IRA in your name. Since the funds are after-tax, you have already paid tax on these dollars. Thus when you convert to a Roth, there are no taxes. This is where the mega backdoor Roth IRA earns its name. 

Not only does this allow high earners who do not qualify for a Roth to contribute to one, but it also allows you to fund it with vastly more than the usual $6,500 limit. If you are looking to take your savings and investing to the next level and wondering where to save that next dollar, this is a strategy worthy of attention.

Lord of the Roths

Roth IRAs have been receiving a lot of attention lately, thanks to Peter Thiel. PayPal co-founder and venture capitalist Peter Thiel was able to turn a $1,700 investment in a self-directed Roth IRA in 1997 into a tax-free $5 Billion account by 2021, earning him the nickname, “Lord of the Roths.” To be clear, Peter Thiel did not break any laws, he only took advantage of the tax-free characteristics of the Roth IRA.

What to look out for

This is a complicated strategy with several steps to follow. It is not always possible (nor the right choice) to pursue. To implement this optimally, you need two critical features offered by your employer’s retirement plan.

  • After-tax contributions are allowed. For employees, this is out of your control and up to your employer and 401(k) plan provider. While the IRS allows after-tax contributions, not all 401(k) plans allow it. According to Vanguard, in 2020, only 19% of plans offered employees the option to make after-tax contributions. Recently, the big trend has been companies, especially in tech and biotech, adding these types of features to their 401(k) plan to incentivize and retain staff and executives.
  • The 401(k) plan allows in-service distributions. An in-service distribution will enable you to roll over the after-tax contributions you made immediately to a Roth IRA while you are still working. Otherwise, you want to be able to convert your after-tax contributions instantly to the Roth 401(k) part of the plan. If neither of these options is available, the strategy won’t work as intended.

The best way to check on the availability of these options is to contact your HR department or your plan administrator.

Can a sole-proprietor use a mega backdoor Roth IRA?

This strategy can work for a sole-proprietor, but the key is to have a solo 401(k). This method won’t work with a SEP IRA or a SIMPLE IRA as those plans don’t allow after-tax contributions. The same core features will be necessary within the plan, and many solo 401(k) providers can accommodate this. This can make the plan more costly to administrate, but it could be worth it if you are looking to execute this strategy.

Who is suited for this strategy?

A mega backdoor Roth IRA is best for someone already maxing out other savings and investment accounts and doesn’t intend to use the funds until retirement. Ideally, you would already be doing the following:

  • You are maximizing your tax-deferred contributions to a 401(k) and have an emergency fund.
  • You don’t have any high-interest rate debts.
  • If you have a Health Savings Account eligible health plan, you are already contributing to your HSA.
  • You are regularly saving into a taxable brokerage account and maxing out other accounts, such as an Employee Stock Purchase Plan.

Once you have those core pieces, a mega backdoor Roth IRA should be seriously considered.

Check to see if you are eligible for a mega backdoor Roth IRA by taking this free test

Things Can Change

Keep in mind that tax law and legislation are constantly changing. The news of Peter Thiel’s $5 Billion Roth IRA spurred scrutiny of wealth built inside tax-free Roth IRAs and the ways people can sidestep eligibility rules. The recent “Build Back Better Plan” from 2021 had a clause that would have stopped the ability to make voluntary after-tax contributions to all 401(k)s, eliminating this mega backdoor Roth method. While the bill didn’t pass, I expect to see future bills targeting strategies like this. It is a reminder that implementing particular investment and tax planning strategies can evolve as laws change, creating obstacles and new opportunities.

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