For over twenty years Roth accounts have given us the freedom to grow our investments tax-free. With Roth accounts, you pay taxes on the contributions today and avoid taxes later when you withdraw funds for retirement. Now with income tax cuts and limits on stretch IRAs enacted in the last three years, Roth accounts are a better idea than ever. Another feather in Roth’s cap is there are no mandatory withdrawals for retirees. If you don’t use all of your Roth accounts in retirement, they are ideal to leave to the next generation for income and estate tax reasons.
You probably know that Roth IRAs can be funded up to $6,000 a year in 2021 ($7,000 if you turn 50 by the end of the year), but only if you have a modified AGI of under $198,000 for the year. Luckily for higher earners, most 401(k) and other employee funded retirement plans have a Roth option. This means you may be able to put $19,500 a year ($26,000 for those 50 and over) into a Roth account regardless of your income.
These contribution limits are more than enough for most of us, but what if you’re a super saver? Recently we have seen the introduction of so-called Mega Backdoor Roth features in workplace retirement plans. A Mega Backdoor Roth begins with voluntary after-tax contributions to a retirement plan. After-tax contributions are not the same as pre-tax savings in traditional retirement plans nor are they tax-free Roth accounts. Voluntary after-tax contributions are a third type of deposit that certain retirement plans can accept. The idea is that once you make after-tax contributions to your plan, soon thereafter you can move the funds over to a Roth 401(k) account inside the plan or a Roth IRA outside of the plan. Then those funds can grow tax-free.
Unfortunately, few employers have 401(k) plans that offer Mega Backdoor Roth features. If you’re fortunate to work for Google, Facebook, or Microsoft, you just need to follow the directions from the plan administrator to get going on your Mega Backdoor Roth.
Luckily, Mega Backdoor Roth accounts are not limited to employees with access to a top-drawer retirement plan. If you work in a business in which the only full-time employees are owners, you may be eligible to set up a solo 401(k) plan with Mega Backdoor Roth features. This is not a task for those who crave simplicity! You need to find a third-party administrator (TPA) with a plan document that permits voluntary after-tax contributions. I should warn you that many custodians such as Vanguard, Schwab, and Fidelity do not allow after-tax contributions in their own low-cost solo 401(k) plan documents. But there’s a way around this restriction.
Companies such as mysolo401k.net have an upfront charge (often under $500) as well as a smaller annual fee to establish and maintain a solo 401(k) plan with Mega Backdoor Roth features. In return, you can open your accounts at your investment company of choice. It opens up the possibility that you could put in up to $58,000 into tax-free savings for 2021 ($64,500 if 50 or over) as long as you earn at least that amount of income.
I realize that few of you save enough to take advantage of the Mega Backdoor Roth. In that case, I encourage you to first max out your Roth IRA every year and unless you’re a high income earner consider making Roth contributions to your workplace retirement plan. With trillions being spent to fight the health and economic challenges of COVID-19, paying taxes now in return for lifetime tax-free growth in a Roth account could be a shrewd financial move.
David Gardner is a Certified Financial Planner at Mercer Advisors practicing in Boulder County. The opinions expressed by the author are his own and are not intended to serve as specific financial, accounting, or tax advice.