How to Contribute an Extra $37,000 to Your Roth IRA

Roth IRAs have always been attractive, due to their capacity to generate tax-free income in retirement. But today, they are even more desirable. The new lower income tax rates (courtesy of last year’s Tax Cuts and Jobs Act) make Roth IRAs more appealing to high-income earners, especially for those who have supplemental after-tax dollars to invest.

The downside to Roth IRAs has always been their income restrictions. In 2019, if the income of a married couple exceeded $203,000 (or $137,000, if single), then they would be ineligible to put money directly into a Roth IRA.

However, under certain circumstances, after-tax dollars can be indirectly placed in a Roth IRA, and one way to accomplish that is through the so-called Mega Backdoor Roth IRA.

How the Mega Backdoor Roth IRA Works

The first thing you must do is check with your employer to see if your 401(k) plan allows you to make after tax contributions beyond the maximum tax-deductible limit ($19,000 per person/per year, or $25,000 with a “catch-up” contribution, if over age 50.)

Less than half of employers offer this kind of 401(k), but if your plan allows it, then you can conceivably contribute up to an additional $37,000 after-tax dollars per year into your 401(k).

You might be asking, “Why would I contribute after-tax dollars into my 401(k)?” and that’s a good question. But there are two good answers:

  • First, after-tax dollars in a 401(k) grow tax-deferred, meaning the earnings are not taxed until withdrawn. As a result, more of your money is re-invested and growing. It’s true there are other accounts that also offer tax-deferred growth but there’s a significant difference.
  • Second, the advantage of making after-tax contributions into a 401(k) is those funds can be rolled over into a Roth IRA, upon retirement or separation of service from your employer. For high-income earners who are ineligible to contribute to a Roth IRA, this is big news. As long as your 401(k) allows after-tax contributions, there are no income restrictions. And then, when you leave your company, that money can be converted to a Roth IRA.

How It Pans Out in Real Life

Jim is 56 years old and is still working for his employer. Let’s assume that he contributes the maximum annual amount of $19,000 to his 401(k), plus an additional $6,000 because he’s over 50, bringing Jim’s total contribution to $25,000.

For a variety of reasons, Jim has extra cash to save this year. He likes the idea of putting this money into a Roth IRA because it can be withdrawn tax-free upon retirement but unfortunately, he is excluded from doing so because he made too much money.

Since there are no income restrictions with after-tax contributions into a 401(k), Jim decides to put an additional $12,000 into his account and to pursue a Mega Backdoor Roth IRA strategy instead. 

For each of the next five years, Jim does the same thing, gradually building up his after-tax contributions to $60,000. Eventually, he decides to retire and now he wishes to transfer his money out of his 401(k) plan.

He requests two checks—one for his after-tax contributions and one for his pre-tax contributions, in addition to his earnings. He deposits his pre-tax money, plus his earnings, into a traditional IRA account. He then deposits his after-tax check into a Roth IRA account.

If Jim had only made direct contributions into a Roth IRA—assuming he was income eligible—he would have been limited to the annual maximum amount of $7,000 ($6,000 limit, plus an additional $1,000 for being over 50.) But because he utilized the Mega Backdoor Roth IRA strategy via his 401(k), Jim significantly increased the amount of money he could save in a Roth IRA on a yearly basis. 

Jim is now a happy retiree who has a healthy sum of money in his Roth IRA that can be withdrawn tax-free—unlike his traditional 401(k). Plus, a Roth IRA is not subject to the Required Minimum Distribution rules, meaning Jim is not forced to withdraw money from his account at age 70 ½. 

Is a Mega Backdoor Roth IRA Right for You?

Like Jim in our example, if you have extra after-tax money to save for retirement, then a Mega Backdoor Roth IRA could be a great strategy for you. But these kinds of tax-saving tactics can be very complex and it would be wise to consult with a financial advisor before proceeding.

At WealthBridge, we will thoroughly analyze your personal circumstances, investment goals, and any other tax-saving strategies you might have in place to determine if a Mega Backdoor Roth IRA is right for you. We’re here to help you maximize your retirement contributions, every step of the way.

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