Physicians often have high incomes, which can make them ineligible to contribute to Roth IRAs directly.
Luckily, there is another powerful retirement savings strategy for high-earners.
The Mega Backdoor Roth enables high-income earners to contribute to a Roth IRA and/or Roth 401(k) by using after-tax 401(k) contributions. Even better, with this savings strategy, you can contribute more money to a Roth IRA than the annual contribution limit.
Let’s take a look.
Key Takeaways
- The Mega Backdoor Roth strategy could allow you to roll over up to $43,500 in after-tax dollars annually into a Roth IRA or Roth 401(k).
- By moving your money to a Roth IRA and or Roth 401(k), your contributions won’t be subject to the required minimum distribution rules, which means that you can retain control over when you choose to take distributions from a Roth IRA.
- Proper utilization of the Mega Backdoor Roth requires an employer-sponsored 401(k) plan that permits after-tax contributions and in-service withdrawals.
Traditional IRA vs. Roth IRA vs. Roth 401(k)
Before we look into Mega Backdoor Roth, let’s first examine how a Traditional IRA, Roth IRA, and Roth 401(k) work.
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Traditional IRA
- Tax deductible; subject to taxes upon withdrawal
Traditional IRAs are individual retirement accounts that, similar to traditional 401(k)s, allow you to contribute pre-tax money to different types of investments. The difference is that these accounts are not employer-sponsored and individuals can establish an account at any time.
Another feature is that you are not limited to the defined set of investment options available to them through an employer-sponsored plan such as a 401(k).
With a traditional IRA, investments are contributed on a pre-tax basis and the money grows tax-deferred until it is withdrawn in retirement, when withdrawals are taxed as ordinary income.
As of 2023, investors can contribute a maximum of $6,500 per year to their traditional IRA accounts or $7,500 if the investor is over 50.
As an investor, you can contribute to both a 401(k) and an IRA, up to each account’s maximum annual contribution limit. For 401(k), the limit is up to $22,500 (or $30,000 for those 50 or older).
Roth IRA
- Taxed upfront, not subject to taxes upon withdrawal
A Roth IRA is a retirement account that allows investors to contribute after-tax dollars to investments; the money grows tax-free and is not subject to taxation upon withdrawal.
As with a traditional IRA, there are limits to the amount of money that an investor can contribute to a Roth IRA per year – contributions are allowed of up to $6,500 per year or $7,500 if the individual is 50 or older. Then, contributions may be limited or phased out depending on income level.
One of the main advantages of using a Roth IRA for retirement savings is the ability to make tax-free withdrawals during retirement. For example, many investors who expect to retire in a higher tax bracket than their current one will benefit from utilizing a Roth IRA as opposed to a traditional IRA.
Unfortunately, Roth IRA income limits disqualify many high earners, such as physicians, from contributing to a Roth IRA. If your modified adjusted gross income (MAGI) is more than $153,000 in the tax year 2023 ($228,000 if married, filing jointly), you can’t contribute to a Roth IRA at all. Hence, this disqualifies most physicians.
While Traditional IRAs do not have income ceilings, they might not be your best option. If your income is too high to make direct Roth IRA contributions, then your income will also be too high to claim a tax deduction for traditional IRA contributions. This would basically eliminate the tax benefit of contributing to a traditional IRA.
Your Roth IRA and Roth 401(k) contributions won’t be subject to the required minimum distribution rules, which means that you can retain control over the timing of your distributions from a Roth IRA.
Roth 401(k)
- Tax upfront, not subject to taxes upon withdrawal
A Roth 401(k) is a retirement savings account that is sponsored by an employer and funded using after-tax dollars. When you contribute to a Roth 401(k), the contributions are made on an after-tax basis. This means that your Roth 401(k) contributions are deducted from your paycheck after taxes have already been paid on those earnings.
Your employer will deduct the elected amounts from your paycheck which then goes into your Roth 401(k) account. When you withdraw money from a Roth 401(k), the earnings are not taxable if you meet certain requirements: you must have been contributing to the account for at least the previous five years and be at least 59½ years old.
For tax year 2023, the contribution limit for individuals is $22,500, or $30,000 if you are age 50 or older.
What is a Backdoor Roth IRA?
A Backdoor Roth IRA is a strategy that allows high earners who are excluded from Roth IRAs to convert their traditional IRA to a Roth IRA.
They can do this by first contributing to a traditional IRA and then converting it to a Roth IRA. There are no income limits on Roth conversions.
The rules have changed several times since Roths were first created. Prior to 2010, your AGI had to be less than $100,000 to convert your traditional IRA to a Roth IRA.
The AGI cap prevented higher-income earners from contributing to Roth IRAs. However, under the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), those previously ineligible became eligible to participate starting in 2010. Also, the 10% penalty tax normally imposed on early or excess distributions from an IRA was removed for funds converted to a Roth.
The limits to the number of Roth conversions you can do were also lifted in 2010, allowing you to convert smaller amounts over several years.
Keep in mind, while there is no specific conversion limit, if you have pre-tax money in your traditional IRA, you may not be able to move it into a Roth account due to the IRS’s pro-rata rule. We’ll explain the pro-rata rule further below.
We covered this strategy in our previous post here: Backdoor Roth IRA 2023: A Step-by-Step Guide with Vanguard
Related read: The 2023 Backdoor Roth FAQ
What is a Mega Backdoor Roth IRA?
Now that we’ve defined the different retirement savings plans available to you, it’s time to get to the meat of this article. What is a Mega Backdoor Roth IRA and why should you care?
In simple terms, a Mega Backdoor Roth IRA is a retirement savings strategy that allows high-income earners to take the after-tax dollars they contribute to their 401(k) and roll them into a Roth IRA. With this strategy, investors are essentially contributing more money to a Roth IRA than the annual contribution limit.
As mentioned above, the annual contribution limit for Roth IRAs in 2023 is $6,500 or $7,500 for those aged 50 or older. But with a Mega Backdoor Roth IRA, high-earners can use their after-tax contributions to contribute up to the annual contribution limit in their 401(k) or 403(b).
After-tax contributions refer to the amount of money you contribute to a 401(k) or 403(b) after you’ve reached your 401(k) or 403(b) employee contribution limit. These contributions are made with after-tax dollars, so they won’t reduce your taxable income.
To be clear, you can’t make the after-tax contributions required for a Mega Backdoor Roth until you’ve reached your 401(k) employee contribution limit.
The 401(k), 403(b), and Roth 401(k) contribution limit for 2023 is $22,500 for employee contributions. If you’re age 50 or older, you’re eligible for an additional $7,500 in catch-up contributions, which raises your employee contribution limit to $30,000.
Mega Backdoor Roth Limit (2023)
After you’ve reached your 401(k) employee contribution limit, you can make after-tax contributions within your plan, as long as these contributions do not make you exceed the combined employee and employer contribution limit. Also, your total contributions cannot exceed your annual compensation at your company.
The combined employee and employer 401(k) contribution limit is $66,000 for 2023 (or $73,500 for those age 50 or older).
Let’s look at an example:
Julie is 50 and a doctor working for a hospital.
Julie’s 401(k) employee contributions were: $30,000
Her employer matching contributions were: $10,000
Her employer’s non-elective contributions were: $10,000
Julie’s after-tax contributions were: $23,500
Julie and her employer combined 401(k) contributions total: $73,500
By implementing this strategy, she could move $23,500 (her after-tax contribution amount) into a Roth IRA or Roth 401(k).
‘If Julie’s employer did not make any employer matching or non-elective contributions, she could have moved $43,500 in after-tax contributions to a Roth IRA or Roth 401(k). You can see why this is called a “Mega” Backdoor Roth as this strategy could allow those who are eligible to potentially move an extra $43,500 into a Roth IRA or Roth 401(k) each year.
If you’re worried about exceeding the combined employee and employer contribution limit, here’s a simple calculation you can do. First, add up your total employee pre-tax contributions and the total amounts your employer has made in matching and non-elective contributions. From there, you can figure out how much you could add to the after-tax portion without exceeding the combined limit.
Mega Backdoor Roth Conversion: How Does It Work?
To use a Mega Backdoor Roth IRA strategy, you must have a 401(k) or 403(b) plan that allows after-tax contributions.
Once you’ve made after-tax contributions to your plan, and if your plan allows, you can then roll this portion over to a Roth IRA while you are still employed. This is done through what is called an in-service rollover. An in-service rollover is a transfer of money from a retirement savings plan to another retirement savings plan while you’re still employed.
Alternatively, if your plan allows, you could do a rollover from your plan to a Roth 401(k) while you are still employed. This is done through what is called an in-plan conversion.
Not all plans offer after-tax contributions or in-service rollovers or in-plan conversions, so you’ll need to confirm with your plan administrator.
If your 401(k) plan is a Roth 401(k) account, it can only be rolled over to a Roth IRA. In this scenario, you can either open a new Roth IRA for your rollover from your 401(k), or you can roll them over into an existing Roth.
For a traditional 401(k) plan, implementing this involves the following steps:
Scenario 1: Make after-tax contributions to your 401(k), then convert these amounts to a Roth 401(k). Some employers allow you to do a direct rollover from a traditional 401(k) to a Roth 401(k) within your employer’s retirement plan (also called an in-plan conversion or in-plan Roth conversion). However, not all employers offer this option, so you’ll need to check with your plan administrator; or
Scenario 2: Make after-tax contributions to your 401(k), then roll over these amounts to a Roth IRA. You’ll need to check with your employer’s plan administrator if they allow direct rollovers from a traditional 401(k) to a Roth IRA while you are still employed; or
Scenario 3: Make after-tax contributions to your 401(k). If your 401(k) plan doesn’t allow in-plan conversions to a Roth IRA, you’ll then roll over these after-tax contributions to a traditional IRA. After you roll over the after-tax contributions to a traditional IRA, you’ll convert these to a Roth IRA.
After determining that you’re eligible, you’ll then choose the timing, or if you want to periodically roll over your after-tax contributions. Note that when you roll over your after-tax contributions from your 401(k) or 403(b) plan to a Roth IRA or Roth 401(k), you’ll have to pay taxes on any earnings that have accrued on those contributions. Once the money is in your Roth IRA, it will grow tax-free and can be withdrawn tax-free in retirement.
Also, if you choose to roll over to a Roth 401(k) within your employer’s plan, you’ll be limited to the funds available in that plan. This is why it’s generally preferable to roll over to a Roth IRA, which offers a wider range of investment options.
And if you have an existing Roth IRA already, it’s generally preferable to roll over your 401(k) to your existing Roth IRA rather than to a newly opened Roth IRA because of the five-year rule regarding qualified distributions (which we’ll cover below).
For 403(b) plans, the rules for in-service rollovers vary depending on your specific plan and your employer. Some plans may not allow you to do an in-service rollover, or they may allow for in-service rollovers once you’ve reached a certain age or meet other terms and conditions. Service withdrawals from 403(b) plans are unique because of the in-service distribution rules, so you’ll want to clarify further with your plan administrator.
Other Benefits to the Mega Backdoor Roth IRA
As mentioned earlier, by moving your money to a Roth IRA, your contributions won’t be subject to the required minimum distribution rules, which means that you get to retain control over when you choose to take distributions from a Roth IRA.
Also, If you have a large amount of wealth to pass on, a Roth IRA is one of the best ways to transfer wealth. This is because Roth IRAs allow your savings to grow tax-free while Roth IRAs don’t have required minimum distributions during your lifetime, allowing your Roth IRA assets to pass on to your heirs tax-free.
With a regular Roth IRA, you can withdraw your contributions penalty-free if it’s been more than five years since you first contributed to any Roth IRA. With conversions, you have to wait five years from when you convert. This feature is beneficial because it allows you to keep less of your emergency savings in cash, and instead, your savings can be invested in stocks, which provide higher growth than cash over the long term.
In addition, by the time you’ve reached 59 ½, you could even reduce your taxable income by covering your living expenses with your Roth IRA after-tax income alone, as Roth IRA qualified withdrawals after 59 ½ are tax-free.
Who Should Consider a Mega Backdoor Roth?
At this point, you may be thinking that this is a great strategy and want to implement it. But before you call your plan administrator to start the strategy, you’ll want first to make sure that the following areas apply to you:
- You have an eligible 401(k) or 403(b) plan at work.
- You’re not eligible to contribute to a Roth IRA because of your income (although you may be able to fund an annual Backdoor Roth IRA).
- You’ve already maxed out your traditional 401(k) contributions. You can’t make the after-tax contributions required for a Mega Backdoor Roth until you’ve reached your 401(k) employee contribution limit.
- You have additional money that you want to invest for retirement.
- You can wait until age 59 ½ before you anticipate needing to take withdrawals from your Roth IRA
Other Considerations:
So far, we’ve covered how the strategy works, how to check if you are eligible, and the benefits. However, there are some other areas you’ll still need to consider as we cover below.
The Pro-Rata Rule
The Pro-Rata Rule is used to determine how much of a distribution from a qualified retirement account, such as an IRA or 401(k) is taxable when the account contains before and after-tax dollars.
The rule states that if you have both pre-tax and after-tax money in these accounts, you’re not allowed to just withdraw the after-tax money and convert it to a Roth IRA without paying taxes. For example, your 401(k) is funded with 80% pre-tax dollars and 20% post-tax dollars. When you withdraw this amount, will consist of 80% taxable and 20% non-taxable money. The taxable money would be taxable at your ordinary income tax rate.
The pro-rata rule can apply to 401(k)s when trying to make a Mega Backdoor Roth conversion. This rule becomes an issue for Mega Roth conversions when there are pre-tax and after-tax dollars within the 401(k). If your employer tracks your pre-tax and post-tax contributions separately, you may be able to only withdraw the post-tax contributions to make the conversion.
Also, to avoid creating taxable income on the post-tax contribution amounts during the conversion, don’t invest these after-tax contributions. Your contributions should remain in cash so as to maintain their value and not accumulate earnings to avoid the pro-rata rule.
Contribution Deadline
Make your additional tax-free contributions in your 401(k) or 403(b) up to the annual limit before year-end, so as to maximize your contributions each year. The contribution deadline for these plans is the end of the calendar year. This is unlike the deadline to contribute to IRA accounts, where you’re allowed to make contributions up to the tax filing deadline for the year (which typically falls on April 15 of the following year).
Untaxed Funds
Any conversion of funds in a retirement plan to a Roth will be reported on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. Though the distribution is included on the form, you will have to calculate how much of the distribution is taxable on Form 8606.
Solo 401(k)
If you’re self-employed and don’t employ others, you may have a solo 401(k) plan. Your solo 401(k) provider may not allow for after-tax contributions and in-service withdrawals by default. You’ll need to check if your plan does, and then customize your plan to allow for these.
Debt
Most people don’t earn enough to cover their monthly expenses to afford to put away more after-tax dollars into a tax-advantaged account. You should evaluate your complete financial picture when considering this backdoor Roth strategy.
Pre-Tax Contributions
The Mega Backdoor Roth strategy is designed to take advantage of after-tax contributions within a 401(k) or 403(b). These contributions are made with already-taxed income, which means the tax implications are minimized when you convert them to a Roth IRA. However, it’s important to note that pre-tax contributions don’t have the same tax advantages, which is why it’s generally not recommended to include them in the conversion.
Converting pre-tax 401(k) contributions to a Roth IRA is a separate process, and can carry significant tax implications. When you convert pre-tax contributions, you’ll owe income tax on the entire converted amount in the year of the conversion. Also, when you convert pre-tax 401(k) contributions to a Roth IRA, the amount you convert is treated as taxable income in the year of the conversion. This can result in a significant income tax bill, especially if you have accumulated a substantial balance in your pre-tax 401(k)..
Mega Backdoor Roth Alternatives
An alternative to this strategy is to contribute to either a Roth 401(k) plan or a solo 401(k) plan. While you won’t be putting away as much as a Mega Backdoor Roth, you are still investing towards your retirement, but without contributing a large amount all at once.
If your employer’s plan doesn’t allow for in-service withdrawals or distributions, you’ll need to wait until you separate from your employer to roll over any after-tax money in your plan into a Roth IRA.
Is This Strategy Legal?
Roth conversions are legal as of the time of this writing, but there have been proposals made to limit the use of Roth conversions. Recently, House Democrats proposed a prohibition on converting pre-tax IRA and 401(k) plan funds to Roth savings for wealthy taxpayers. The repeal of such Roth conversions would start after a decade, in 2032.
Under the Ways and Means tax proposal, Roth conversions would be prohibited for individuals with taxable income of more than $400,000 and married couples with taxable income of more than $450,000 as of Dec. 31, 2031. We know that legislation in Congress can take some time, and it remains to be seen whether these proposals will become law.
However, until a new law is passed that sets limits on Roth conversions, this continues to be a great strategy for high-income earners.
Final Thoughts
A Mega Backdoor Roth IRA is a retirement strategy that allows high-income earners to contribute to a Roth IRA. It also allows investors to contribute more money to a Roth IRA than the annual contribution limit.
While this strategy has many benefits, it also has many components. And if done incorrectly, could lead to a huge tax bill. Therefore, before proceeding, you’ll want to consult your plan documents, understand the process, be clear about each step, pay attention to important areas such as what your employer plan allows, and the pro-rata rule, and then implement it carefully. Lastly, consider how the rules could change if you switch employers down the road, and also keep records of your conversions, tax payments, and any related paperwork for your financial records.
Happy savings!
