Everyone thinks about saving for retirement, and not many people want to work forever. However, have you thought about the best way to save for the future? If you are setting aside the yearly max in your 401(k) and channeling extra savings to your brokerage, you might be missing out on powerful tax-advantaged saving opportunities. In this article, we will show you how we help clients maximize savings, minimize taxes and secure their future using the Mega Backdoor Roth IRA.
Most people know they can contribute to their employer’s retirement plan from their paychecks through pre-tax and Roth contributions up to $19,000 a year ($25,000 if age 50 or older; IRS, 2018). What people miss is whether their retirement plan allows for additional after-tax contributions beyond this limit. Enter the supercharged savings!
It turns out that some company plans permit you to contribute up to the IRS maximum for total contributions to a retirement plan, which is $56,000 in 2019 ($62,000 with catch-up contributions; IRS, 2018). The IRS maximum counts contributions from all sources, including pre-tax employee deferrals, employer matching contributions, and even after-tax contributions for the Mega Backdoor Roth. That means you might be able to contribute an additional $20,000 or more after-tax each year after maxing your elective deferral and receiving your match. You can then convert the extra after-tax savings to Roth dollars tax-free. This more than doubles what most individuals can contribute to their retirement plan, and you won’t have to pay taxes on your Roth account distributions in retirement. This benefit is even greater when both spouses have this option available through their employers, so be sure to check both plans.
Retirement plans like those at Boeing, Facebook, and Microsoft permit easy conversions of after-tax to Roth dollars within the retirement plan. Other companies offer a variation where you can make in-service distributions and move after-tax dollars into a Roth IRA. Make sure to check with your benefits team to find out if your company’s retirement plan supports after-tax contributions and Roth conversions, the steps involved and the maximum amount you can contribute to the after-tax portion of your retirement plan. It’s important not to run afoul of plan rules or IRS requirements, so also be sure to consult experts like your accountant or financial advisor if you have any questions.
Why contribute extra after-tax? Now that we have covered the high-level view, let’s hammer down the why. The benefit of contributing to your employer’s after-tax retirement plan is that those contributions can subsequently be converted to Roth tax-free. This is sometimes called a ‘Mega Backdoor Roth,’whereby you can contribute and convert thousands of dollars per year depending on your retirement plan. Once converted, these Roth assets can grow tax-free and be distributed in retirement tax-free. After several years of Mega Backdoor Roth contributions, you can amass a meaningful amount of wealth in a tax-free retirement account
How do I contribute? 1. Log in to your employer’s retirement plan through their provider website, such as Fidelity.
2. Find the area where you change your paycheck and bonus contributions (i.e., deferrals).
3. Find “after-tax” on the list showing how much you elected to contribute pre-tax, Roth, or after-tax to your 401(k).
4. Enter a percentage to have withheld after-tax from your upcoming paychecks and bonuses that works for your budget.
5. Select an automated conversion schedule, such as quarterly (Microsoft’s retirement plan even offers daily conversions!). If your plan doesn’t offer automated periodic conversions, contact your retirement plan provider regularly throughout the year to convert the assets.
6. Remember to select an appropriate investment allocation for your retirement account that aligns with your overall investment plan.
Is any part of the conversion taxed? For retirement plans that don’t convert after-tax contributions to Roth daily, there may be growth in the account prior to conversion. This growth is subject to taxation at ordinary income tax rates. For example, if you converted $22,000 ($20,000 contributions + $2,000 investment growth over the period), you’ll owe income tax on the $2,000.
We suggest speaking with a Merriman advisor to determine if your retirement plan allows additional after-tax contributions, how to fit it within your budget and its impact on your retirement savings goals.
Often employers offer the option of contributing to a traditional 401(k) or a Roth 401(k). Do you know which one is right for you?
The primary difference is in the tax treatment. The traditional 401(k) gets a tax benefit at the time of contribution, because money contributed to such an account is not taxed. Moving forward, the earnings in your traditional 401(k) are not taxed as long as the funds remain in the account. When you begin to make withdrawals in retirement, the funds withdrawn are taxed as ordinary income.
Roth 401(k)s are taxed the reverse way. In these accounts, money is taxed when the contribution is made. Earnings on investments in your Roth 401(k) account are not subject to tax, and the money is not taxed when it’s withdrawn.
If the investor’s marginal tax rate is the same at the time of contributions and withdrawals, the traditional and Roth accounts would produce the same results.
Because of these differences in tax treatment, taxpayers in the lowest tax brackets should contribute to Roth accounts, while taxpayers in higher tax brackets will want to use traditional retirement accounts. As a general strategy:
When you’re in the 12% tax rate or lower: Contributions should be made to a Roth 401(k).
When you start moving into the 22% tax bracket: 50% of contributions be made to a traditional 401(k), and 50% to a Roth 401(k).
In your peak earning years: As you move into years with marginal tax rates above 22%, most or all retirement contributions should be made into a traditional 401(k) instead of the Roth.