If you've read any of my quotes in the media (ranging from CNBC to Nerdwallet) you'll know my full fledged appreciation for the Roth IRA. I graduated college at age 20 and my boss and mentor gave me 2 tips-utilize your 401(k) at least to get the full company match AND max out of a ROTH IRA. At the time I didn't understand the full benefits of the ROTH IRA but now that I work as a Financial Planner and understand the tax implications of having, tax free nest egg * (as long as you follow the IRS distribution rules) I wish more investors understood the power of starting a ROTH IRA early on. Especially young professionals in their 20s and 30s, who still haven't reached their peak income years and thus their highest marginal tax bracket years and have 30+ years of compounding ahead of them to build a sizable tax free retirement asset. Not only that, but a ROTH IRA also has the benefit of allowing you to take contributions (money you put in) out of it for emergencies and other things that might come up between now and when you're 65 and retiring. Let's face it, life is unpredictable, so that flexibility to me and other young investors is worth something.
The biggest downfall with the Roth IRA is this-the IRS limits your contributions to $6K per year (if you're under 50) and if your income reaches certain thresholds you're no longer eligible for the ROTH IRA. You'd then have to do a backdoor ROTH IRA (which is a work around that we help clients execute).
Now what if you're a self employed individual, say a Realtor, Dentist, Lawyer or other 1099 Freelancers and have a solo 401(k) or are thinking about setting one up? I have good news-if your plan document sponsor allows it, this gives you the opportunity to Mega Backdoor Roth IRA. In an oversimplified sentence that means doing a backdoor ROTH IRA up to $38,500 for 2021 and $40,500 for 2022 respectively.
The mega backdoor Roth allows you to put up to $38,500 of after-tax dollars in a Roth IRA or Roth 401(k) in 2021, and $40,500 in 2022. Add the regular contribution limits of $19,500 ($26,000 for those 50 and older) for those accounts in 2021 and $20,500 ($27,000 for those 50 and older), and you can contribute up to $58,000 in 2021 and $61,000 in 2022 total to a ROTH 401(k).
Here’s a quick summary of what you need to have in place for the ideal mega backdoor Roth strategy:
This is pretty straightforward: Either your employer plan allows after-tax contributions or it doesn’t. Check with your Financial Advisor/Plan document sponsor.
If it does, here’s how to figure out the maximum amount you’re allowed to put into the after-tax portion of the plan:
If your plan doesn’t allow in-service withdrawals to a Roth IRA or in-plan rollovers to a Solo Roth 401(k), then search for a different plan document provider/financial advisor who can help you execute this strategy. Much of our value add as advisors comes from guiding our clients on strategies that can better your financial situation but I'd argue that execution is just as important, if not more. Most of the young successful professionals we work with are extremely intelligent yet lack the time to put all the pieces of their financial plans together.
You can leave this money in this "after tax" bucket, but it's not as tax advantaged because you'd then have to eventually pay taxes on the earnings so moving it to the "Roth" bucket seeks to get it growing and compounding in the "tax free" bucket so you're reaping a bigger harvest without the taxes you'd have if it was a regular 401(k) account that gives you a tax break when you contribute. It's the difference of paying taxes on the seed (Roth 401(k)) versus paying taxes on the harvest.
A mega backdoor Roth IRA is a strategy I read about some years back to optimize Roth IRA dollars, but it’s really for folks who have a lot of money to put aside for savings. We usually utilize this for professionals making over $150,000 a year looking to supercharge their retirement savings. In general, it makes sense to first max out a regular or Roth 401(k) and a Roth IRA, if you’re eligible because it's the path of least resistance. Here’s why:
If you’re unable to do a mega backdoor Roth, don’t lose any sleep over it. Seriously, FOMO isn't good for your health or wealth. The mega backdoor strategy is just one of a handful of ways to enjoy the tax benefits of the Roth treatment, where your money potentially earns investment returns that you’ll never owe taxes on. And if tax rates increase in the future (to help pay for our growing national debt for example) you'll be glad you have a that account to draw from. Now unfortunately my crystal ball is currently under repair so I don't know what future taxes will be (higher, lower, the same). What I do know is it pays to diversify your tax buckets just like it makes sense to invest your money across different asset classes.
And don’t forget that if you’re saving and investing for retirement in any type of tax-advantaged account, you’re already ahead of the game. Give yourself some credit!
If you'd like to schedule a call to discuss this strategy click here: Schedule a call with Tess
*If you're over 50 years old you can utilize the catch up as well.