If you fall into the group affectionately called HENRYs (High Earners Not Rich Yet) by various publications, you’ve likely watched enviously as friends have been able to amass large tax savings, year after year, by using Roth IRAs as a tax-sheltered way to grow their income. Of course, they pay taxes on the money that they stash away now, but it’s allowed to grow tax-free, making the total amount tax-free when withdrawn. Remember that with Roth IRAs, this can occur at any time, even before reaching 59.5 years of age. Unfortunately, there is a limit to how much you can earn in any year and still contribute to a Roth IRA, which prevents many investors from taking advantage of this account. If you find yourself above the threshold, but still want to take advantage of the Roth IRA, you’re in luck. You’ll just have to sneak through the backdoor to do so.
Unfortunately, the backdoor isn’t as clandestine as it sounds, and some people have been using it for years. “Backdoor” merely refers to a little-known tax rule that allows owners of traditional IRAs to convert these accounts into Roth IRAs. Anyone regardless of income can contribute to a traditional IRA. That said, if your income is sufficiently high, you will not be able to reap the tax saving benefits associated with doing so (reducing your taxable income by the amount that you contribute to your traditional IRA). Using a Backdoor Roth IRA conversion, you can contribute to a traditional IRA account, then convert those funds into a Roth IRA, where despite having paid the taxes up front, you can still take advantage of the future tax benefits. Hence the “backdoor” terminology. While you can’t directly contribute to a Roth IRA as a HENRY, you can indirectly contribute using this method. But, as always there a few things to consider before doing so.
One of the benefits of using the backdoor method of funding a Roth IRA is that there are no income limits, nor are there any conversion limits. Even if you have $100,000 socked away in a traditional IRA that you’ve been funding for a while, you can convert the entire balance to a Roth. This is true whether you earn $80,000/yr. or $8,000,000/yr.
Ironically, the biggest headache that you’ll run into during the conversion is trying to figure out the tax implications. This won’t pose an issue if you’re just starting out because the maximum that you can contribute each year is only $5,500, but if you decide to convert your entire traditional IRA account balance of say $100,000, the taxes on those funds become due that year. Remember that over the years, you were able to take advantage of the tax benefits associated with the IRA, namely you could reduce your taxable income by the amount you contributed. Well, that’s only half of the deal. The other half is that you pay the taxes on both the principal and the capital gains when withdrawn.
Another issue is that if you aren’t careful, you may accidentally kick yourself into a higher tax bracket by converting funds from a traditional to a Roth IRA. This is because the IRS will likely treat any amount that you convert as income earned in that year. So, if you have a large balance in your traditional IRA and you’d like to convert the entire amount, consider converting portions each year such that you maintain your current tax status.
Further complicating the situation (although not by much) is the pro-rata tax rule for partial conversions. Under this rule, if you elect to convert just a portion of your traditional IRA, you’ll need to figure out what portion of your total IRA balance (include all IRA accounts that you own) is made up of after-tax funds, then apply that percentage to the amount that you elect to convert. This will be the portion of the converted funds that you will be required to pay taxes on. For example: If you had a traditional IRA balance of $95,000 (where you claimed the tax deductions in prior years) and contributed an additional $5,000 on an after-tax basis throughout the year bringing your total balance to $100,000, your pre-tax contribution percentage would be 95%. If you then decided that you wanted to convert $50,000 from the traditional account into a Roth account, then you would need to pay taxes on 90% of the $50,000, or $45,000.
How It’s Done:
There are two ways to do this –
Contribute money to a traditional IRA, sell the shares you’d like to convert, then convert the money into a Roth IRA
Work with your broker/plan administrator to roll your entire account into a Roth account
Overall, the good probably outweighs the bad here, and this provides a way for high earners to take advantage of another tax-advantaged account. You can even withdraw money from your Roth IRA before 59.5 years of age if you have had the funds in your account for at least 5 years. If not, you’d be subject to a 10% penalty, but only on the portion for which you have not paid taxes on. This is typically a very small amount (could even be $0) which may be a small price to pay considering that your capital gains have grown tax-free.
The $30,000 Secret
As promised, there is a secret that could be worth about $30,000 a year for some. While the backdoor Roth has grown in popularity, an even lesser-known tax rule actually allows savers (and spenders in this case) to turbocharge your backdoor IRA contribution. Before we dig into that, there are a few things that need to be clarified. The first thing you’ll need to note is that while the elected contribution limit for 2018 is only $18,500, the total amount that you can stash away in retirement accounts is actually $55,000. And don’t worry, you don’t have to wait until retirement to withdraw it. The $18,500 refers to the amount that you can elect to have deducted directly from your paycheck, but remember that employer matches, profit sharing, and other contributions can be made on your behalf by your employer. The total of all contributions may not exceed $55,000 for the year.
Next, note that there is a difference between “after-tax” contributions and “Roth” contributions. “Roth” refers to the fact that your money will grow tax-free. When you withdraw the funds, you are not required to pay taxes on any portion of the final amount. This includes both the principle and the appreciated value. “After-tax” refers to the money that you see in your paycheck. This money has already been taxed, and if your income allows, you may be allowed to direct it towards a Roth account, but you could just as easily stash it in CD’s, a savings account, or a non-tax-advantaged brokerage account. This can be a little confusing, but it’s key to understanding the next step. You can think of it this way: Roth contributions are made with after-tax money, but after-tax money is not necessarily Roth.
Finally, we get to the secret… the Mega Backdoor Roth IRA. Unfortunately, this option will not be available to everyone, but for those that can use it, it can dramatically boost your tax savings. The Mega Backdoor Roth IRA conversion essentially treats any after-tax 401k contributions as if they were a Traditional IRA. This means that you can convert any after-tax (not Roth) 401k contributions into a Roth IRA, and take advantage of all the benefits mentioned in the previous section.
Consider the following situation:
Dan, a junior corporate attorney makes $200,000/yr. Through his employer-sponsored 401k plan, he stashes away $18,500, but he would like to save even more on a tax-advantaged basis.
Scenario 1: Regular Backdoor Roth IRA
Dan can contribute after-tax funds in the amount of $5,500 to a traditional IRA, for which he receives no tax benefit due to his salary. He can then convert this money into a Roth IRA, allowing his money to grow tax-free until he is ready to withdraw it. He doesn’t need to wait to withdraw the funds either. Should he withdraw the money in 5 years, it’ll be tax and penalty free. Should he withdraw funds prior to 5 years, he still will not owe any taxes, but he may be subject to a 10% penalty on only the capital gains portion of the withdrawal. This will likely be a small amount if he withdraws the money in less than 5 years, and the 10% penalty compares favorably to his capital gains tax rate anyway.
Scenario 2: Mega Backdoor Roth IRA
Let’s assume that Dan’s employer contributes an additional 6% of his salary to his 401k plan. So in addition to the $18,500 that he contributed personally, he has an additional $6,000 from his employer for total retirement contributions of $24,500 and has an additional $30,500 left that he can contribute. He can place this amount into his 401k on an after-tax basis, convert it into a traditional IRA (recall there are no conversion limits) then convert this into a Roth IRA. He now has $30,500 in an IRA account that will grow tax-free until he needs it. Should he need to withdraw it early, he can do so after 5 years penalty and tax-free, and if he needs to access the funds sooner than that, he’ll only pay a 10% penalty on the portion of the funds that he hasn’t yet paid taxes on.
Before you can take advantage of the Mega Backdoor Roth IRA you’ll need to make sure that your employer-sponsored retirement savings program allows two things. The first is after-tax (not Roth) contributions. Without this, you’re out of luck (join the club). Next, your plan will need to allow either in-service withdrawals or in-plan conversions. If you’re plan doesn’t offer either of the latter, you may still be able to use the mega backdoor Roth if you plan to leave your employer in the future. Once you leave, you can transfer your funds, no strings attached.
And there you have it, the $30,000 secret that financial advisors don’t want you to know about.
Are you planning to take advantage of any of these benefits? Do you have any experience using either of these methods to save money on a tax-advantaged basis? Let us know in the comments below!