The Roth IRA stands out as one of the most potent tools in your financial arsenal. It not only offers tax-deferred growth but also provides tax-free distributions in your retirement years, ensuring a reliable income source.
Recent tax legislation has opened up unique planning opportunities for Roth IRAs. This article will delve into one such strategy, the mega back door Roth, which we will discuss in detail.
Let's start by discussing a Roth IRA, its advantages, some of its associated rules, and why someone would need to use the "back door "Roth. Once we have a solid foundation for the basics of the Roth, we will discuss the mega back door Roth and why it's such a robust financial and tax planning strategy.
As always, consult a CPA or tax advisor to implement any of the strategies discussed in this blog. You can always schedule a discovery phone call with Tennessee Tax Solutions, and we will help you understand your options.
What is a Roth IRA?
A Roth IRA is a retirement account anyone can open to determine if they have earned income.
A Roth IRA can be opened at any well-known investment banks or brokers you've probably heard of, including Charles Schwab, Vanguard, Morgan Stanley, E*Trade, and several more.
Roth IRA, once opened, is funded with after-tax dollars from your bank account. You then invest the money as you deem appropriate. Most people invest their Roth IRA portfolios in stocks, ETFs, mutual funds, bonds, and real estate. You can also open your Roth IRA with a self-directed custodian and invest your money in promissory notes, local real estate projects, and business startups. It is essential to understand your overall financial plan and long-term goals so that you can pick a suitable investment portfolio inside of your Roth IRA. Again, please consult with a qualified professional, CPA, or tax advisor in your area to determine the most appropriate strategy for you.
What are some rules associated with funding and withdrawing from a Roth IRA?
If you are under 50, you can contribute up to $7000 to a Roth IRA; if you are over 50, you can contribute up to $8000. These contribution limits are annual and typically adjusted for inflation every year.
Since a Roth IRA is a retirement account, you are generally expected to keep the money until you reach 59 1/2. You can withdraw 100% of the account at that time without paying any income tax or early distribution penalty if the account has been open for five or more years.
You can withdraw your contributions to a Roth IRA at any point without paying income tax or early distribution penalty. If you distribute or withdraw before age 59 1/2, only the earnings inside the Roth IRA will be taxed and assessed a 10% early distribution penalty. There are some rare exceptions to this 10% penalty rule, such as distributing funds to pay off an IRS debt, withdrawing some money to buy your first home, and withdrawing money to pay medical bills. Please consult with a CPA or qualified professional before making a distribution to ensure you understand what you are doing.
Your income may restrict your ability to fund a Roth IRA in a given year. Single taxpayers cannot fully fund a Roth IRA if they make more than $146,000 in 2024. This income limit is also adjusted annually for inflation. We will revisit this rule shortly as we segue into the importance of our mega backdoor strategy.
Why is a Roth IRA such a great tool?
Investors generally seek financial accounts that give them two or more of the following: liquidity, tax deductions/tax "breaks," tax-deferred growth, and tax-free income and withdrawals.
A Roth IRA checks almost every box, offering some level of liquidity, tax, deferred growth, and tax-free income.
Contributions to the Roth can be withdrawn at any time (liquidity), money inside the Roth is not taxed as it grows (tax-deferred growth), and income can be taken from the Roth IRA after age 59 1/2 without generating a tax bill (tax-free income). However, you do not get a tax break on the money you initially saved into the Roth.
Many investors believe it is acceptable to forgo a tax break today because they assume higher tax rates will be higher in their retirement years, make more money in the future, and would like to control their income tax bill in those years. Understanding that they have IRA money to pull from in retirement provides peace of mind that legislation changes cannot disrupt their financial plan and retirement income stream.
What is a backdoor Roth strategy?
As mentioned, people who make less money cannot directly fund a Roth IRA. I don't know the intent behind this tax legislation, but that's where we are today.
However, people who make too much money can indirectly fund a Roth IRA by utilizing a strategy known as the backdoor Roth.
I will describe this for the scope of this article. To execute a backdoor Roth, a taxpayer would make a nondeductible contribution to a traditional IRA and subsequently convert that to a Roth IRA. That conversion transaction is not taxable nor penalized since the nondeductible contribution was never given a tax deduction, and the money was never withdrawn. It was converted between two retirement accounts, resulting in a successful contribution to a Roth IRA.
This method is possible because taxpayers with any income can make a nondeductible contribution to an IRA.
Which brings us to….
What is a Mega Back Door Roth?
As you may have recognized by now, the Roth IRA is a powerful tool. Anyone can fund a Roth IRA through the backdoor Roth strategy. However, the annual contribution limits are relatively low: $7000 for people under 50 and $8000 for people over 50. People who need a multimillion-dollar portfolio in retirement to sustain their lifestyle will not be able to achieve this with these relatively low annual contribution limits.
This is where the mega backdoor Roth strategy comes into play.
Case study.
Let's assume Lanie is under the age of 50 and makes $300,000 as a single taxpayer. The mega backdoor Roth strategy starts with Lanie successfully executing a total contribution to a Roth IRA by utilizing the backdoor. She now has $7000 in a Roth IRA.
Lanie also contributes $23,000 to her Roth 401(k) or solo Roth 401(k). Lanie has now contributed $30,000 into Roth-style retirement accounts (please note that Roth 401(k) plans work the same way from a tax perspective as a Roth IRA does).
Lanie then makes $46,000 in contributions to her after-tax 401(k) account.
The last step involves Lanie converting that $46,000 after-tax contribution into her Roth 401(k) account. Unlike the conversion between the nondeductible IRA and the Roth IRA, the conversion from the after-tax 401(k) to the Roth 401(k) does not result in tax or penalties.
This whole process resulted in Lanie successfully funding Roth accounts with a total of $76,000, which will grow tax deferred and be taken out in her retirement years income-tax-free. Using the mega backdoor Roth IRA process, Lanie has successfully increased her annual Roth account contributions by $69,000.
Please note that there is a total 401(k) funding limit of $69,000 in 2024 for someone under 50. Please also know that your 401(k) may or may not allow after-tax contributions and in-plan conversions. Please consult with your plan administrator to determine if this is possible. Also, please note that if you are self-employed and operating with a solo 401(k), there are safe harbor regulations to consider. If you have full-time employees, please consult your CPA or tax advisor to execute the mega backdoor Roth strategy properly.
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