When it comes to retirement savings, higher earners often face limitations on certain tax-advantaged accounts like Roth IRAs due to income restrictions. However, there is a lesser-known strategy that could benefit those looking to maximize tax-free growth for their retirement savings. Mega backdoor Roth conversions offer a way for individuals to surpass Roth IRA income limits and contribute more to their retirement accounts. This strategy can be particularly advantageous for high-income earners who have already maxed out other tax-advantaged options.
Mega backdoor Roth conversions involve shifting after-tax 401(k) contributions to a Roth account. This allows individuals to take advantage of tax-free growth on their investments, something that is not possible with traditional brokerage accounts. By making after-tax contributions above the yearly deferral limits set by the IRS, investors can transfer these funds to a Roth account and kickstart tax-free growth. This strategy is especially beneficial for those who would have otherwise invested their extra money in a brokerage account subject to annual taxes on capital gains and dividend distributions.
For the year 2024, the adjusted gross income limits for direct Roth IRA contributions are $161,000 for single filers and $240,000 for married couples filing jointly. However, the pretax or Roth 401(k) deferral limit for the same year is $23,000, with an additional $7,500 catch-up contribution allowed for savers aged 50 and older. The total 401(k) limit, including deferrals, employer matches, profit sharing, and other deposits, is $69,000. It is important to note that not all 401(k) plans permit mega backdoor Roth conversions, with only about 11% of plans allowing this strategy as of the end of 2023.
While after-tax contributions to a Roth account do not incur immediate taxes, there may be levies on the growth of these contributions. Unlike Roth contributions that grow tax-free, after-tax investments are tax-deferred, meaning regular income taxes will apply to withdrawals in retirement. To minimize upfront taxes on the conversion, experts recommend converting after-tax funds regularly. By executing this strategy correctly, individuals can potentially avoid taxation on all growth in their retirement savings, providing a significant advantage for high-income earners.
Mega backdoor Roth conversions offer a valuable opportunity for higher earners to increase tax-free retirement savings beyond the limits of traditional Roth IRAs. By taking advantage of after-tax 401(k) contributions and transferring these funds to a Roth account, individuals can benefit from tax-free growth on their investments. While this strategy may not be suitable for everyone, particularly those with 401(k) plans that do not allow for mega backdoor Roth conversions, it is worth considering for individuals looking to maximize their retirement savings and reduce tax implications on their investments. Consulting with a financial advisor or tax professional can help individuals determine if mega backdoor Roth conversions are the right strategy for their financial goals.