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Mega Backdoor Roths Can Help 401(k) Participants Supersize Retirement Savings by Jeffrey M. Mutnik, CPA/PFS

Posted on August 13, 2021

Employer-sponsored 401(k) plans are excellent vehicles for individuals to save for retirement during their prime earning years. Annual contributions made today with pretax dollars grow tax-deferred until you reach retirement age, when the distributions you take are treated as taxable ordinary income. However, even if you are diligent and contribute the maximum allowable amount to your plan each year, you may be missing out on a great opportunity to bolster your retirement savings with tax-free withdrawals in the future.

The IRS dictates the maximum amount individuals may annually contribute to their retirement accounts. For example, you can contribute up to $19,500 (or $26,000 if age 50 or older) to a 401(k) plan in 2021 and as much as $6,000 (or $7,000 if age 50 and above) to an IRA and, if qualified, receive a tax deduction today. In return, you will be obliged to pay taxes on required minimum distributions after you reach age 72. Both these strategies work well for individuals who expect to earn less income in their golden years and would therefore pay ordinary income taxes at a lower rate than they would during their high-earning years.

By contrast, a Roth IRA requires taxes to be paid up front, in the years of contributions, in exchange for tax-free withdrawals in retirement. However, unlike a 401(k) or IRA, a Roth does not come with minimum distributions requirements in retirement. This strategy makes sense for high-net-worth individuals whose marginal tax brackets will not change significantly after they stop working and who may not need to access their savings to support their lifestyles at that period of their lives.

Wealthy Investor Challenges

The challenge for wealthy individuals is that they will not qualify to participate in Roth IRAs because their modified adjusted gross income exceeds the limits set by the IRS, which for 2021 is $140,000 for individuals or $208,000 for married couples filing joint tax returns. In those circumstances, workers may consider a backdoor Roth IRA.  However, if funds are available for additional savings, a little-known strategy called a mega backdoor Roth allows them to supersize their retirement savings and tax efficiency today as well as in retirement.

If your 401(k) plan allows, you may be able to make additional contributions above the annual $19,500 tax-deductible limit. For example, in 2021, the maximum amount that can be contributed to a 401(k) plan is $58,000, or $64,500 if you are age 50 or older. That includes your salary deferral of up to $19,500 tax-advantaged contribution (or $26,000 if age 50 or older), an employer match (if available), and any non-deductible contributions you make on top of that. This will leave you with two buckets of retirement savings: one with pre-tax dollars and one with after-tax dollars. If your plan allows, you may then rollover the after-tax money into a Roth and pay taxes only on investment gains.

As you continue this process year after year, your contributions with have the potential to grow significantly with the benefit of compounding interest and market gains. Because there is no requirement to take annual withdrawals from a Roth in retirement, that growth can continue throughout your life and allow you to pass those assets onto heirs after your death.

About the Author: Jeffrey M. Mutnik, CPA/PFS, is a director of Taxation and Financial Services with Berkowitz Pollack Brant Advisors + CPAs, where he provides tax- and estate-planning counsel to high-net-worth families, closely held businesses and professional services firms. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or via email at info@bpbcpa.com.