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You may have heard that you can’t contribute to a Roth IRA after your income reaches a certain level. That’s not entirely the case.
You also may have heard that an employee can’t contribute more than $22,500 to a 401(k), 403(b), or 457(b) for 2023, plus $7,500 in catch-up contributions for workers who are age 50 or older. But for employees whose employers have two key features in their plans, this is also not entirely accurate.
Not knowing the truth about how much you can contribute could be costing you an opportunity to save far more for retirement. If you’re a high-income earner, you should know how to increase your tax-advantaged savings through so-called backdoor Roth IRA and mega-backdoor Roth contributions.
Who a backdoor Roth IRA is for
Backdoor Roth contributions are for people who can’t contribute to a Roth IRA the regular way — directly, or "through the front door” — because their income is too high. What’s “too high” depends on the tax year and your filing status.
For 2023, your ability to contribute directly to a Roth IRA phases out when your modified adjusted gross income (MAGI) reaches $218,000 to $228,000 if you’re married and file jointly, or $138,000 to $153,000 if you’re single, head of household, or separated and don’t live with your spouse at all.
Why not just contribute to a traditional IRA instead, then?
If either you or your spouse are covered by a workplace retirement plan and your income is too high for direct Roth IRA contributions, then your income will also be too high to claim a tax deduction for traditional IRA contributions, eliminating a major benefit of contributing to a traditional IRA.
You could go ahead and make after-tax contributions to a traditional IRA and still enjoy tax-deferred growth. But you’d owe income tax on distributions related to that growth.
You’d also need to take required minimum distributions (RMDs) once you reach age 73 (age 75 starting in 2033). And the IRS would consider all your distributions to come from a combination of pretax and after-tax contributions, further complicating your income tax calculations.
People in this situation will likely find that indirectly contributing to Roth accounts — where money grows tax free, can generally be withdrawn tax free, and can be used at your discretion without RMDs — is a better option.
How to make backdoor Roth IRA contributions
The contribution process is simple.
- Make an after-tax contribution to a traditional IRA. All this means is that you won’t claim this contribution as a deduction on your federal tax return. You can contribute up to the annual maximum (which for tax year 2023 is $6,500) or your total earned income, whichever is less. You can add another $1,000 if you’re 50 or older. If you have a nonworking spouse, you can contribute to an IRA on their behalf as well. Just make sure that the total contributions don’t exceed your combined incomes.
- Don’t invest the contributions. To keep everything simple, you want your contributions to remain in cash, where they won’t lose value or accumulate earnings. If you were to contribute the maximum, accumulate earnings, then move the entire amount to a Roth, you’d have an excess contribution that you’d have to correct.
- Do a Roth IRA conversion. Online or by phone, tell your financial institution that you want to move your after-tax traditional IRA contribution into a Roth IRA. It’s best to do this step as soon as the traditional IRA deposit clears your account and before it has a chance to earn interest. If both IRAs are not at the same financial institution, request a trustee-to-trustee transfer rather than withdrawing funds and moving them yourself, which can create a tax liability.
Once the money is moved, you’re done. The execution is really that easy. But there’s more you need to know before deciding whether to do it.
Backdoor Roth IRA mistakes and complications
This strategy works best if you don’t have any money in any type of pretax IRA, whether a traditional IRA, SEP IRA, or SIMPLE IRA. If you do, then following the steps above can have major tax implications.
The pro rata rule
The pro rata rule says that if you have both pretax and after-tax contributions in a traditional IRA, you can’t just roll over the after-tax contributions. Any partial rollover will be considered to include pro rata amounts of both. The result? You’ll owe income tax on the amounts that come from pretax contributions.
Tax withholding
If you will owe taxes on your backdoor Roth conversion because of the pro rata rule, you may need to make an estimated quarterly tax payment to avoid penalties for not paying enough income tax during the year at the time you incur the tax liability.
In addition, you’ll want to pay any tax you owe from a non-retirement account. If you elect to have taxes withheld from your conversion and you aren’t at least 59½, the withheld taxes will count as a distribution because money is coming out of your retirement account. That means they will likely be subject to the 10 percent early distribution penalty — even though you’re sending money to the IRS.
Tax filing requirements
In January of the following year, your brokerage firm will send you a Form 1099-R showing that you received a distribution from your retirement account. When you get this form, you might panic and wonder where you messed up.
There’s no need to panic, but you do need to pay close attention to how you report the transaction when you file your annual federal tax return.
On your 1099-R, a box should be checked to indicate “taxable amount not determined.” Another box should be checked to indicate “total distribution.” You’ll also see a box with a distribution code number, and that number should correspond to “early distribution, exception applies.” (If you are over 59 ½, the number in this box will correspond to “normal distribution.”) All this information needs to get transferred to your tax return, whether you’re entering your 1099-R into tax software or a professional is preparing your return.
If you’re filing your own return with tax software and you see your tax liability increase after you enter this form, check your tax software’s instructions to see if you need to enter the information differently.
You’ll also need to file Form 8606 to report the nondeductible contribution you made to a traditional IRA.
How to contribute to a mega-backdoor Roth
You must have a 401(k), 403(b), or 457(b) plan that lets you do two things:
- Make after-tax contributions.
- Take in-service distributions.
After-tax contributions aren’t the same as Roth contributions (although those contributions are, indeed, made with after-tax dollars). In-service distributions allow you to withdraw money from your workplace retirement account while you still work there.
Your retirement plan administrator — the company that issues your employer’s retirement account statements — can tell you if you have this option and the steps required to execute it, which you may be able to do online. If the plan administrator doesn’t understand what you mean by “mega-backdoor Roth,” which is more of a colloquial term, ask if the plan allows for after-tax contributions and in-service distributions.
How much you can contribute
In 2023, your total 401(k) contributions can be up to $66,000. This limit, called the “annual additions limit,” is made up of three broad subcategories of contributions:
- Employee contributions, which can be up to $22,500 and can be either regular or Roth;
- Employer contributions, including both matching contributions (money your employer kicks in when you contribute to your retirement plan) and nonelective contributions (money your employer kicks in whether you contribute to your retirement plan or not); and
- After-tax contributions, which you can make if the previous two categories didn’t get you to the $66,000 annual limit (which would only be possible with generous employer contributions).
It’s the after-tax contributions that can be used for the mega-backdoor Roth strategy.
If you’re 50 or older, you can also make catch-up contributions of up to $7,500. These count as employee contributions and increase your total possible 401(k) contributions to $73,500.
Here’s an example of an employee who is not making catch-up contributions:
- Employee contributions: $22,500
- Employer matching contributions: $5,000
- Employer non-elective contributions: $5,000
- After-tax contributions: $33,500
- Total: $66,000
Many people don’t have room in their budgets to even max out their employee contributions, let alone make after-tax contributions. But if you do, using the example above, you may be able to save up to $2,791.67 per month, or $1,288.46 per pay period if you’re paid every two weeks, to make mega-backdoor Roth contributions (on top of the $1,875 per month or $865.38 per pay period that you’re already putting toward employee contributions).
In total, under the example above, you would need to be able to save $4,666.67 per month for retirement to max out your annual contributions.
Besides your budget, there’s another caveat: If your retirement plan caps the percentage of your pay that you can allocate to retirement savings, you may not be able to contribute the full $33,500 unless you get a large bonus or start making after-tax contributions in January.
Tax considerations
“Current and future expectations about tax brackets need to be considered in determining whether a mega-backdoor Roth strategy is right for you,” said Chad Tourin, J.D.,CPA, CFP®, and president of Coastal Wealth, a MassMutual firm in Plantation, Florida.
Many people assume that they will be in a lower tax bracket in retirement because they expect to be earning less income. But this assumption “ignores the fact that we have no control over what the actual tax brackets are,” he said, pointing out that from 1932 through 1981, the highest marginal tax rate exceeded 60 percent.
If you believe future tax brackets will be higher, there is a strong case for a mega-backdoor Roth, because all of the account’s growth and qualified distributions will be tax free (under current law).
Future tax policy aside, because you pay ordinary income tax in the year of conversion, both regular and mega-backdoor Roths “are most advantageous in years with low income, which is why it’s more common to see young professionals with large future earnings capacity opting for the backdoor strategy,” Tourin said.
Most people also have state income taxes to consider.
“The state you live and plan to retire in should be considered when deciding if a backdoor Roth is right for you because of the impact of state income taxes,” he noted.
If your state has no income tax, a backdoor Roth could be more appealing since you’ll only pay federal taxes on the money you convert. If your state does have an income tax, you’ll want to know whether it exempts portions of IRA distributions.
“If you are retiring somewhere with no state income tax, backdoor Roths are less valuable because there likely wouldn’t be additional tax owed at the state level,” Tourin said.
Another advantage
An added bonus is the opportunity to withdraw your contributions penalty free (and, of course, tax free). With a regular Roth IRA, you can generally do this if it’s been more than five years since you first contributed to any Roth IRA. With conversions, however, you have to wait five years from when you convert.
This feature gives you access to additional liquidity should you have an emergency down the road. Though it’s generally not advisable to withdraw funds from retirement accounts before you retire, it’s nice to know the money is there if you need it.
This peace of mind could allow you to keep less of your emergency savings in cash, where it will typically lose value to inflation every year even when held in a high-interest savings account. Instead, if you have the appetite for more risk, you could keep more money in stocks, which can outpace inflation.
The option to tap Roth contributions can also help those who want to retire early and sidestep penalties.
Conclusion
The backdoor Roth IRA, and especially the mega-backdoor Roth IRA, are more advanced strategies. You may not be sure whether they make sense for your circumstances, that you fully understand the risks and benefits, or that you can execute the strategies without making any costly mistakes.
When you’re trying to take your net worth to the next level, working with a financial professional can give you the confidence that you’re moving in the right direction.
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