Wealthy clients should know now about a twist on a familiar retirement-savings tool that can save them on taxes.
Particularly advantageous to high-income earners, a mega backdoor Roth IRA allows investors to contribute up to $37,000 extra in their Roth IRAs. This is made possible by leveraging the fact that some employer 401(k)s allow after-tax contributions up to the current limit of $56,000.
“The perfect candidate will be someone who has sufficient cash flow,” said Lawrence Pon, a CPA/PFS and CFP at Pon & Associates, Redwood City, Calif., who frequently presents seminars discussing mega backdoor Roths.
“To implement the strategy, your employer must allow for after-tax contributions to your retirement plan. They also have to allow for in-service distributions so those after-tax contributions can be rolled into a Roth IRA,” said Bruce Primeau, a CPA/CFP and president at Summit Wealth Advocates in Prior Lake, Minn.
For example, the 401(k) contribution limit for 2019 is $56,000, including employee and employer contributions. A saver makes either pre-tax 401(k) contributions or after-tax Roth 401(k) contributions totaling $19,000. Assuming the employer allows after-tax contributions to the 401(k) plan and doesn’t offer a matching contribution, the saver can make up to $37,000 of additional after-tax contributions. If the employer allows in-service distributions, the saver can then roll over the after-tax portion of contributions to a Roth IRA.
Under tax reform, the maximum federal income tax rate has been reduced to 37%, which makes a Roth conversion less costly than in the past, according to John Vento, a CPA/CFP and president at Comprehensive Wealth Management in New York. “As we get closer to the 2020 election, I believe the popularity of all Roth conversions may increase, especially the mega backdoor Roth, if it appears there will be a significant federal tax increase in the coming years,” he said.
Mega Roths come with the advantages of regular Roths, such as no RMDs at age 70½ and tax-free withdrawals for beneficiaries. “For estate planning, the beneficiaries will not be paying income tax on the Roth IRA [but] they will be required to take RMDs,” Pon said.
There is a catch: The 401(k) must meet certain criteria and “most participants will likely not be able to take full advantage of the $37,000 limit,” said Billy Lanter, fiduciary investment Advisor at Unified Trust Company in Lexington, Ky. “If your employer contributes to the plan through matching, which most do, this counts towards the $37,000 in capacity and reduces the amount you can save in after-tax contributions. An individual must be able to max out their deferrals and still have an appetite and ability for additional savings. The final hurdle is that your plan must also allow for in-service distributions or non-hardship withdrawals.”
The criteria also relates to retirement plan discrimination and annual contribution percentage tests, added Ryan Linenger, a partner at the Chicago office of Plante Moran.
“This ability to contribute more than one’s 401(k) deferral limit to a non-deductible portion of the 401(k) will mostly be feasible for highly compensated employees, [which] makes this feature difficult to put in place for many retirement plans,” Linenger said.
According to Vento, a mega backdoor Roth IRA conversion may not be right in the following circumstances:
• If your income will be significantly lower in your retirement years and you’ll be in a much lower tax bracket.