How I Saved $90,000 in a Roth IRA over 3 Years

The Mega Post on the Mega Backdoor IRA

You’ve heard of the Roth IRA.  Your income determines whether you qualify to contribute or not.

If you make too much to contribute to a Roth, you’ve heard of the backdoor Roth IRA.  This is a perfectly legal way to contribute to a Roth IRA even if you make too much income.  However, the mechanics can get complicated if you have any money in a rollover IRA, traditional IRA, or SEP-IRA.

Enter the mega-backdoor IRA.  This bypasses any income limits AND bypasses the issue of having money in pre-tax retirement accounts (rollover, traditional, SEP).  This technique has the potential to let you save up to $35,000 PER YEAR in a Roth IRA!

But its not for everyone. Let me explain.

What is a Roth IRA?

The Roth IRA is an individual retirement account allowing a person to set aside after-tax income up to a specificied amount each year.  For 2018, that amount is $5,500 and $6,500 if you’re over 50 years old. Both the earnings on the account and the withdrawals after age 59 1/2 are tax free.

Pretty cool, right?  No one knows what tax rates will be in the future.  You know what you’re tax rates are now.  Why not pay the tax now, then not have to worry about tax rates ever again?

My method is to have a mix of both pre-tax and post-tax retirement accounts so that I can manage my tax rate in the future.  I can explain more in another post.

There are a lot of benefits to the Roth.  The money is never taxed.  There is no required minimum distribution so you can pass the Roth along to your heirs.  Your heirs can then allow it to grow tax free…imagine the compounding.

You can also withdraw the contributions at anytime.  We have that in our backpocket as a last resort to pay for some our children’s college.

What is the backdoor Roth IRA?

The backdoor Roth IRA is a legal way to set aside money into a Roth IRA if you make over the income limit to contribute to a Roth.

If you are single, you must have a modified adjusted gross income under $135,000 to contribute to a Roth IRA for the 2018 tax year, but contributions are reduced starting at $120,000. If you are married filing jointly, your modified adjusted gross income must be less than $199,000, with reductions beginning at $189,000.

The way the backdoor Roth IRA works is that you set aside money in a non-deductable traditional IRA account.  Since there’s no income limit on conversions, you immediately convert that traditional IRA account to a Roth.  Since its non-deductible, you never took a tax deduction for it so the money is technically after-tax money.  This makes the conversion very smooth.

However, if you have any money in other pre-tax retirement accounts (i.e. rollover, traditional, SEP, etc), you will be hit with the pro-rata rule.  This only allows you to convert a portion of the account and creates complications with your tax return.

Money that’s in a 401k account is not included in the pro-rata rule, so one way to get around this is to transfer all your pre-tax retirement accounts to your company’s 401k (assuming they allow transfers).

You can read a lot more on the technicalities of the backdoor Roth here.

The Mega Backdoor Roth IRA

The Mega Backdoor Roth IRA is a technique that allows you to save up to $35,000 a year in a Roth IRA.

On September 18, 2014 the IRS published new guidance on allocation of after-tax amounts when making a rollover from a 401k or similar plan. You may benefit if you’ve made after-tax contributions (other than Roth contributions) to the retirement plan where you work.

How To Execute the Mega-Backdoor Roth IRA

In order to take advantage of the mega backdoor Roth IRA, you will need to check 2 things:

  1.  Does your employer allow “in-service distributions”? All this means is that you are able to rollover some portion of your 401k while you’re still employed.  You can still do the mega-backdoor Roth IRA if your employer doesn’t allow for in-service distributions, but there’s huge risk and uncertainty with the ability to rollover when you leave your employer at some point in the future.
  2. Does your employers allow for after-tax contributions to your 401k.  This is the most critical step.  If your employer doesn’t allow for this, then you’re out of luck.

Ok, here are the steps I took to take advantage of the mega backdoor Roth IRA for the last 3 years and successfully saved $90,000 in a Roth IRA.

  1.  Call your employer’s human resources department and find out if you’re able to make after-tax contributions to your 401k plan.  There is a distiction between Roth 401k contributions (which are technically after tax contributions), but you’re not talking about that.  Ask if you’re able to contribute up to the $55,000 maximum from all sources (pre-tax, Roth, employer contribution, and post-tax).  If the answer is “YES”, then you’re in luck.
  2. Calculate how much you can contribute.  See the example below:
    1. Your salary is $100,000 and you contribute 18% to your 401k (pre-tax).
    2. Your pre-tax 401k contribution is $18,000
    3. Your employer matches $1 for every $1 you put in up to 6% of your salary.  Your employer contribution is $6,000
    4. The total between your pre-tax contribution and your employer contribution is $24,000 ($18,000 + $6,000).
    5. Subtract the IRS maximum allowed total contribution ($55,000) from the number above.  $55,000 – $24,000 = $31,000
    6. Calculate what percent of your income would equal $31,000.  In this example, 31% of $100,000 = $31,000.
    7. You can contribute 31% of your income as a post-tax contribution
  3. My employer allows for in-service distributions twice a year.  Some employers allow once a year.  Call human resources to find out how frequently you’re able to make in-service distributions
  4. Next, ask human resources to make an “in-service distribution of your after-tax contributions to a Roth IRA.”  It makes it very easy if your 401k and your Roth IRA are with the same brokerage.  Mine are both with Fidelity.  If they’re not with the same brokerage, they’ll cut a check that you will immediately have to mail to the brokerage that houses your Roth IRA or there could be tax consequences.
  5. If you’re employer doesn’t allow for in-service distributions, you can still make the after-tax contributions.  You’re option is to roll over the entire portion when you leave your employer.  The big risk there is the uncertainty in the tax code in the future…you could be socking away a ton of after-tax money and not able to rollover to a Roth IRA.  If you can’t, then you’ll have to pay income tax on the gains!  You would’ve been better off investing that money in a taxable brokerage account and only paying capital gains tax.
  6. When you go through this process, you may have some gains on the after-tax portion.  HR will ask if you want to pay the tax on the gains and roll that portion over to the Roth, or if you want to transfer the gains to a traditional IRA.  You can do either.  I roll over the gains to my traditional IRA.
  7. That’s it!  I’ve done it twice a year for 3 years and have been able to save approximately $90,000 in a Roth IRA!

Has anyone else had any luck with this?

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