Tax-Free Income in Retirement: Mega Backdoor and Backdoor Roth Strategies
October 11, 2024
Articles
Carol Ventura, Senior IRA Solutions Manager
Tax-free income during your golden years – it’s not a far-fetched idea if you’re a tax-intelligent financial professional. After all, you’re focused on helping clients live tax-efficiently every day, and preparing for retirement is an important part of that plan.
So how can backdoor and mega backdoor Roth strategies potentially help your clients set aside tax-free income to use in retirement? Avantax Senior IRA Solutions Manager Carol Ventura breaks down the details and shares which clients may benefit from these tax-intelligent retirement contribution strategies.
Roth IRA Basics
Before diving into specific backdoor and mega backdoor Roth strategies, let’s review why a Roth IRA can be a tax-intelligent choice:
- Money contributed to a Roth IRA grows tax deferred.
- If the distributions meet the definition of a qualified distribution, the money withdrawn from the Roth is income-tax free, including earnings on the account.
- Because qualified Roth distributions are tax free, there is no impact on Medicare premiums or Social Security benefits.
- Required Minimum Distributions (RMDs) don’t apply while the account owner is alive. When the account owner dies, the SECURE Act limits the distributions to a period of 10 years for non-spouse beneficiaries, but there are no distributions required years 1-9 with the expectation that the entire account be distributed by the end of year 10.
Backdoor Roth IRA
Consider this option for:
- Clients who exceed income limits.
- Clients in a lower tax bracket today but expecting to be in a higher tax bracket in retirement.
Details:
Typically, this strategy uses a two-step process that allows individuals who exceed the income limits to contribute directly to a Roth IRA:
- Step 1: Your client contributes to a traditional IRA as a non-deductible contribution (i.e. made with after-tax dollars)
- Step 2: Your client immediately converts that contribution to a Roth IRA.
Example:
Your client makes a $7,000 IRA contribution with after-tax dollars. It can then be converted tax free to a Roth IRA if the taxpayer has no other IRA assets, including SEP and SIMPLE IRAs.
Mega Backdoor Roth
Consider this option for:
- Younger clients who are saving for retirement and don’t need the current income tax deduction (successful saving for retirement starts younger with a systematic investment).
- Older clients looking to pass assets income-tax free to their heirs (Roth IRA can be a powerful estate planning tool).
- Clients in a lower tax bracket today but expecting to be in a higher tax bracket in retirement.
- Owner-only businesses (because discrimination testing isn’t required).
Details:
When using the mega backdoor Roth strategy, the retirement plan document must have language allowing after-tax deferrals to be made to the plan. The 401(k) plan participant makes an additional after-tax deferral to the plan. Then, using the in-service distribution language in the plan, the after-tax money can be rolled directly to a Roth IRA. There is no urgency with the rollover of the after-tax money to the Roth IRA, as this can be done when the client retires, the plan is terminated or your client leaves their job.
Examples:
- Your client contributes $23,000 to their 401(k) pre-tax. An additional after-tax contribution can be made up to the standard total plan limit of $69,000 (assuming no other plan limitations apply and there is no additional employer contribution). Note that discrimination testing, plan language and earnings may restrict this after-tax contribution.
- Your client, age 40, is a W-2 employee with an annual salary of $100,000. They are maxing out their $23,000 salary deferral and their employer makes a $25,000 profit-sharing contribution. In this scenario, your client could make an additional $21,000 after-tax contribution to achieve the maximum $69,000.
Starting the Conversation
It can be difficult to shift clients’ focus from purely investment needs and market performance to a comprehensive retirement plan that may help them as they pursue their goals. Here are a few talking points to help start the conversation with your clients:
- Are you interested in passing retirement assets tax-free to heirs?
- Are you concerned with increasing taxes when you retire?
- As you start your working career, consider contributing to a Roth IRA. Not only will this provide possible tax-free funds while you are working, but it also will provide tax-free income during retirement.
- As you know, we look for opportunities to help reduce taxes for you individually, as well as for your business. We can do a plan review to see if the mega back door Roth strategy is available under your existing retirement plan.