Who Should Consider a Mega Backdoor Roth Conversion?

For many folks saving for retirement these days, they have a dizzying array of choices to fund their plan. Heck, just Google “retirement planning” and you’ll get over 4 million hits alone on the subject. You can choose from investments such as stocks, bonds, mutual funds, ETFs, bank CDs and money market funds, insurance products, and the list goes on. You also need to consider the account type that will house your investments, from a tax perspective. For example, funds can be invested in a taxable account – think of a brokerage account or other account in which you pay taxes on your gains each year.

You can choose from pre-tax or “tax deferred” accounts as well. These include your Individual Retirement Account (IRA), your company 401(k) plan, and others that defer taxes on your earnings until you withdraw them in retirement. Your contributions are deducted from your current income each year, potentially reducing the taxes you pay each year while you’re saving but they will be fully taxed when you withdraw them.

The third option is to participate in tax-free accounts, such as the Roth IRA. The Roth involve making contributions with funds that have already been taxed, and then any growth can be taken out tax free (assuming you follow the terms and conditions of the account). This account can be an impressive addition to your portfolio because it allows you to withdraw the funds in retirement as tax free income, which not only puts more money in your pocket but can also help keep you in a lower tax bracket. This in turn may help keep your Social Security benefits from taxation and allow you to pay lower Medicare premiums.

For many folks, a combination of these 3 account types makes sense. You can choose which specific investment vehicles to place in each account, or “bucket”, to create diversified income streams in retirement. Of course, the more money you have in the tax-free bucket, the better off you’ll likely fare in retirement.

But for many high-income earners, the standard Roth IRA is out of reach because there are income limits on who can contribute. Roth IRA income limits are based on modified adjusted gross income, or MAGI, which is your adjusted gross income with some deductions added back in. For example, if your MAGI is more than $161,000 and you're a single filer, or $240,000 for a couple, you cannot contribute to a Roth. 

Take Jeff and Maggie, a nice couple from Falmouth who came to see me recently. In their early 60’s, they are empty nesters who both work full time and earn a combined $270,000 annually. Maggie is an architect and Jeff is a real estate attorney who have both worked their way up to a comfortable income after decades of hard work. 

As we sat down to review the progress they’ve made with their savings, we considered the Roth IRA as a potential option. But unfortunately, their combined income makes them ineligible to open a Roth account. Luckily, they still have options here. 

I told them about a strategy called the mega backdoor Roth, explaining that this strategy is intended primarily for high earners who have excess funds to invest. For example, if you need all your salary to live on, you shouldn’t be contributing thousands of additional dollars into a Roth account. But for Jeff and Maggie, who have plenty of discretionary funds from their income, this makes more sense.

For this strategy to work, I explained that their employer must have a Roth 401(k) retirement plan or permit rollovers to a Roth individual retirement plan. That plan has to accept in-plan Roth conversions of after-tax contributions or in-service distributions of after-tax contributions, meaning those dollars can be rolled into a Roth IRA.

In 2024, you can contribute up to $23,000 of your salary to a Roth 401(k) $30,500 if you are over 50—the same limits as traditional tax-deferred 401(k)s. Most employers now have Roth 401(k)s in addition to traditional 401(k)s, and workers can choose between them.

If your plan permits it, you can make additional after-tax contributions to your Roth 401(k). How much? Well, the IRS says that total contributions to a 401(k) for 2024 can’t exceed $69,000. So, if you’re contributing $23,000 to either a Roth 401(k) or a traditional 401(k), you can add in another $46,000 in after-tax contributions to your Roth 401(k). If you are over 50, the limit is $76,500 because it includes an additional $7,500 catch-up contribution.

That $69,000 or $76,500 is the limit for total employee and employer contributions. If your company is giving you, say, $10,000 in matching funds, you will reduce the amount you can contribute in after-tax contributions by $10,000. 

Some retirement plan administrators have set up programs to make mega backdoor Roth conversions easier. If the employer permits it, some large firms will automatically place after-tax contributions every day into the Roth 401(k). So instead of your unspent salary ending up in a taxable bank or brokerage account, it is going into a tax-free Roth account.

In the world of retirement, a mega backdoor Roth conversion offers tremendous value for high earners that may otherwise lose out on this tax-free opportunity. Make sure you get the retirement planning advice you need so you understand all of your options and make sure you’re not leaving any of your hard-earned money on the table for Uncle Sam. 

So as always - be vigilant and stay alert, because you deserve more!

Have a great week.

Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, an SEC Registered Investment Advisor with offices in Falmouth, Duxbury, and Mansfield, MA. Insurance offered through its affiliate, CutterInsure, Inc.

We do not offer tax or legal advice. Jeff can be reached at jeff@cutterfinancialgroup.com. This information is intended to provide general information. It is not intended to offer or deliver investment advice in any way. Information regarding investment services is provided solely to gain a better understanding of the subject of the article. Different types of investments involve varying degrees of risk, including the potential for loss. Therefore, it should not be assumed that future performance of any specific investment or investment strategy will be profitable. Insurance product guarantees are backed by the financial strength and claims-paying ability of the issuing company. Market data and other cited or linked-to content is based on generally available information and is believed to be reliable. Cutter Financial does not guarantee the performance of any investment or the accuracy of the information contained in this article. Cutter Financial will provide all prospective clients with a copy of Cutter Financial’s Form ADV 2A, Appendix 1, applicable Form ADV 2Bs and Form CRS as well as the firm privacy policy. Please contact us to request a free copy via .pdf or hardcopy.  

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