For those hoping to retire early, or at least before the average retirement age, a mega backdoor Roth IRA can be an effective tool.
Only a certain type of investor will want to employ a mega backdoor Roth IRA as a part of their financial plans. For those people, figuring out how to efficiently save and invest money for retirement can be a challenge. That’s where the mega backdoor Roth IRA enters the conversation.
Below, we’ll walk through what mega backdoor Roth IRAs are and how they work. In addition, we’ll discuss the important details that investors need to know about them.
What is a Mega Backdoor Roth IRA?
The mega backdoor Roth IRA is a retirement savings power move, in which people who have 401(k) plans through their employer—along with the ability to make after-tax contributions to that plan—can rollover the after-tax contributions into a Roth IRA.
Before getting too far in depth, though, it’s important to understand the basics of regular old Roth IRAs.
A Roth IRA is a retirement account for individuals (vs an employer-sponsored account like a 401(k)). Account holders can contribute up to $6,000 per year (or $7,000 for those older than age 50) of their post-tax earnings. That is, income tax is being paid upfront on those earnings—the opposite of a traditional IRA.
The payoff comes later. Individuals can withdraw their contributions at any time, without paying taxes or penalties. For that reason, Roth IRAs are attractive and useful savings vehicles for many people.
But Roth IRAs have their limits—and one of them is that people can only contribute to one if their income is below a certain threshold. In 2022 the limit is $129,000 for single people (people earning more than $129,000 but less than $144,000 can contribute a reduced amount); for married people who file taxes jointly, the limit is $204,000 (or up to $214,000 to contribute a reduced amount).
The Backdoor Roth IRA
Generally, individuals with income levels above those thresholds who wish to contribute to a Roth IRA are out of luck. However, there is a workaround: the backdoor Roth IRA.
A backdoor Roth IRA allows high-earners to fund a Roth IRA account by converting funds in a traditional IRA (which has no limits on a contributors’ earnings) into a Roth IRA. This could be useful if an individual expects to be in a higher income bracket at retirement than they are currently.
However, converting a traditional IRA to a Roth IRA could result in significant taxes, as the IRS will apply income tax to contributions that were previously deducted.
The mega backdoor Roth IRA
Mega backdoor Roth IRAs involve 401(k) plans. People who have 401(k) plans through their employer—along with the ability to make after-tax contributions to that plan—can roll over up to $37,500 in after-tax contributions into a Roth IRA. That mega Roth transfer limit has the potential to boost an individual’s retirement savings.
It’s complicated, and there are a lot of factors at play. But like the backdoor Roth IRA, the mega backdoor Roth IRA is another way to sidestep the normal contribution limits of Roth IRAs.
How to Pull Off a Mega Backdoor Roth IRA
The mega backdoor Roth IRA process is pretty much the same as that of a backdoor Roth IRA. The key difference is that while the regular backdoor involves converting funds from a Traditional IRA into a Roth IRA, the mega backdoor involves converting after-tax funds from a 401(k) into a Roth IRA.
Whether a mega Roth IRA is even an option will depend on an individual’s specific circumstances. These are the necessary conditions that need to be in place for someone to try a mega backdoor strategy:
• You have a 401(k) plan. People hoping to enact the mega backdoor strategy will need to be enrolled in their employer-sponsored 401(k) plan.
• You can make after-tax contributions to your 401(k). Determine whether an employer will allow for additional, after-tax contributions, and what that maximum contribution is. The standard 401(k) contribution limit is $20,500 (or $27,000 for those 50 and older). After-tax contributions allow for the opportunity to save, potentially, tens of thousands more per year. The IRS allows up to $61,000, or $67,500 including catch-up contributions, in total contributions per year.
• The 401(k) plan allows for in-service distributions. A final piece of the puzzle is to determine whether a 401(k) plan allows non-hardship distributions to either a Roth IRA or Roth 401(k). If not, that money will remain in the 401(k) account until the owner leaves the company, with no chance of a mega backdoor Roth IRA move.
If those conditions exist, a mega backdoor strategy should be possible. Your next step: Open a Roth IRA—so there’s an account to transfer those additional funds to.
From there, pulling off the mega backdoor Roth IRA strategy can be deceptively simple—max out 401(k) contributions and after-tax 401(k) contributions, and then transfer those after-tax contributions to the Roth IRA.
But be warned: There may be many unforeseen hurdles or expenses that arise during the process, and for that reason, consulting with a financial professional to help navigate is likely advisable.
Advantages of the Mega Backdoor Roth IRA
Given that this Roth IRA workaround has so many moving parts, it’s worth revisiting wyhy, exactly, someone would be interested in a mega backdoor Roth IRA.
The main advantage of the concept is for those who are earning too much to contribute to a Roth IRA, but who want to take advantage of tax-free growth. Plus, with a mega backdoor Roth IRA an individual can effectively supercharge retirement savings because more money can be stashed away. It can also offer a way to further diversify retirement savings.
The Takeaway
Strategies like the mega backdoor Roth IRA can be used by some investors to help achieve their retirement goals—as long as specific conditions are met, including having a 401(k) plan that accepts after-tax contributions.
While retirement may feel like a lifetime away, especially if you’re early in your career or still relatively young, most financial professionals generally recommend that you start thinking about it sooner rather than later.
With SoFi Invest® online brokerage account you can size up your retirement goals and start making progress towards accomplishing them. SoFi offers Roth or traditional IRAs, as well as other investment vehicles.
SoFi Invest®
The information provided is not meant to provide investment or financial advice. Also, past performance is no guarantee of future results.
Investment decisions should be based on an individual’s specific financial needs, goals, and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC registered investment advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.sofi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or prequalification for any loan product offered by SoFi Bank, N.A.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
SOIN21060
