The Battle of the Roth IRAs: Backdoor vs. Mega Backdoor
A backdoor Roth IRA transfers money from a traditional account to the Roth. The “mega” backdoor is a strategy employed by people with a 401(k) plan at work. It is often pursued by higher-income earners who aren’t able to contribute to a Roth IRA because their income exceeds the limit. Instead of contributing directly to a Roth IRA, they put their money into a traditional IRA and then convert it to a Roth.
Traditional vs. Roth IRA
The traditional allows for a tax break immediately since the taxpayer can take a tax deduction from their contribution in the year it is made. Then, no taxes are required until the money is withdrawn in retirement. Upon withdrawal, the individual will owe taxes on the invested money and the earnings from the investment growth and interest. As mentioned above, the Roth IRA is taxed, so the money can grow and be withdrawn tax-free.
High-income taxpayers face an obstacle due to contribution limits. Individuals earning above a specified amount cannot open or even fund a Roth IRA.
2024 Income Limits
To contribute to a Roth IRA, single filers must have a modified adjusted gross income (MAGI) of less than $161,000. If married and filing jointly, your joint MAGI must be less than $240,000. Then, the contribution amount allowed is reduced for single filers earning between $146,000 and $161,000. If you earn over $161,000, you are no longer allowed to contribute. For married filing jointly, the contribution amount allowed is reduced when joint earnings are between $230,000 and $240,000. Over $240,000, no contribution is allowed.
Backdoor Roth IRA
Pros
- Tax-free growth and withdrawals: Funds are after-tax dollars. They grow tax-free and are withdrawn tax-free as long as all the rules are followed, including being older than 59 ½ and as long as the money has sat for five years in the account.
- Beneficiaries: This strategy may benefit individuals who expect to have funds left in their traditional IRA, who can then pass the money onto their heirs in a Roth IRA.
- No required minimum distributions (RMDs): Unlike 401(k)s, Roth IRAs have no RMDs.
Cons
- Tax implications: A portion or all of the backdoor Roth IRA conversion could be subject to taxes.
- Flexibility of employer’s plan: Your employer’s plan must permit after-tax contributions to a 401(k), plus in-service distributions or conversions.
- Time restriction: Your money must remain in a Roth account for at least five years before you can withdraw it without being subject to a penalty.
- Overfunding: Should the IRS determine that the loophole is a violation, you could be subject to a penalty for overfunding your Roth.
Mega backdoor Roth IRA
Pros
- Potentially minimize taxes: If you transfer funds early in a Roth account, you may save on taxes you would have had to otherwise pay on gains.
- Higher contributions: The mega backdoor Roth allows you to save a total of $69,000 in your 401(k). If you don’t get an employee match, you can contribute up to $46,000 of post-tax dollars into their 401(k) in 2024, on top of the regular 401(k) contribution for 2024 of $23,000 ($30,500 for those 50 and older). You must deduct your employer contributions from the $46,000 if you don’t get an employer match. The funds rolled into a mega backdoor Roth is either a Roth 401(k) or a Roth IRA.
- Tax-free growth and withdrawals: After-tax dollars can grow and get withdrawn tax-free.
Cons
- You may owe taxes: Converting from a traditional 401(k) to a Roth account may trigger a tax burden.
- Time restriction: The money has to sit for at least five years before it can be withdrawn.
- Per employer availability: Your employer’s plan must allow after-tax contributions to a 401(k), plus in-service distributions or conversions.
Consult a financial professional
It is crucial for you to understand how each decision could impact your financial strategy. Before making any decisions, consider consulting your financial professional to help mitigate risk, especially the long-term consequences of making an uninformed decision. With their help, you can carefully review the risks and benefits involved so your money can potentially work for you and align with your long-term financial retirement goals.
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Important Disclosures:
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing.
The information provided is not intended to be a substitute for specific individualized tax planning or legal advice. We suggest that you consult with a qualified tax or legal professional.
Traditional IRA account owners should consider the tax ramifications, age and income restrictions in regards to executing a conversion from a Traditional IRA to a Roth IRA. The converted amount is generally subject to income taxation.
The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.
Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.
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This article was prepared by LPL Marketing Solutions
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Sources:
Backdoor Roth IRA: Advantages and Tax Implications Explained
Backdoor Roth IRA Vs. Mega Backdoor Roth: What Are The Differences?
Impact of Inflation and Interest Rates on Your Financial Plan