By Gary Meeks, RICP®
You have probably heard about the tax benefits of a Roth IRA. Here are the basics: your contributions go into the Roth on an after-tax basis. Qualified withdrawals come out tax free. Unlike a traditional IRA, if you ever withdraw your principal contributions, those withdrawals are not subject to tax penalty since the contributions went into the Roth IRA on an after-tax basis. Tax free withdrawals at retirement may be very appealing, especially if you expect to be in a high tax bracket at retirement; however, not everyone is eligible to contribute to a Roth IRA because there are income limits for eligibility.
The income limits for eligibility to contribute to a Roth IRA for 2021 are as follows. : For single people, you cannot contribute to a Roth IRA if your Modified Adjusted Gross income (MAGI) exceeds $140,000 per year and for married people, $208,000 of MAGI would make you ineligible.
A possible solution is the Backdoor Roth IRA. Here is how it works: whether you are married or single, you make a non-deductible traditional IRA contribution of $6,000 or $7,000 depending on your age, then immediately convert that account to a Roth IRA. There are no income restrictions for this transaction, and no income tax to be paid on the conversion to a Roth unless you have some earnings, which would be taxable. But, if you do the conversion immediately after contributing to the traditional IRA, this would likely be minimal. Regardless of your income, you could use this strategy annually and build a nice nest egg for retirement or leave it income tax free to your heirs. Remember, you do need to have earned income to make contributions to a traditional IRA.
A “Mega Backdoor Roth” Allows High Earners to Maximize Retirement Plan Contributions
Many people are not aware that retirement plan participants can use after tax contributions in a 401k to fund a Roth IRA. If you have been participating in a 401k for many years, you may already have after tax contributions in your 401k. If your employer allows in service withdrawals, you could roll these after-tax contributions into a Roth IRA outside of your 401k. If you are already retired but still have after tax contributions in your 401k, those could be rolled over to a Roth IRA account.
If you are a high earner and are currently maxing out your 401k contributions, there may be a way to contribute even more. Ask your employer if your plan allows for after tax contributions. The IRS allows a maximum of $64,500 in total contributions to a 401k. That includes employee and employer matching contributions for employees 50 or older. For participants under the age of 50, the total maximum would be $58,000 but the strategy would work the same.
So, if your employer allows the after-tax contributions, you can simply increase your 401k contributions until your pretax contributions are exhausted, then the excess becomes after tax contributions, if allowed by your employer, via in service withdrawals, and can be rolled over into a Roth IRA.
Example: A 50-Year-Old Employee Contributes the Maximum to a 401(k)
Employee Maximum Contribution: $26,000
Employer Matching Contribution: $13,000
Total Contribution: $39,000
How can this individual reach the $64,500 limit for 2021 for employees 50 or older?
The employee can make after-tax contributions to contribute an additional $25,500
($64,500 limit – $26,000 employee contribution – $13,000 employer contribution = $25,500)
In this case, the additional $25,500 can be rolled over into a Roth IRA.
Note: Many 401k plans allow for Roth account contributions with no income restrictions up to the IRS limits of $19,500 under age 50 and $26,000 age 50 and over. The after-tax contributions, if allowed by the employer, would allow you to potentially get even more dollars into a Roth IRA.
Consult with your financial or tax advisor to make sure you understand any tax implications or benefits.
Gary D. Meeks, RICP®, is a registered representative offering securities and advisory services through Cetera Advisor Networks LLC, member FINRA/SIPC, a broker dealer and Registered Investment Adviser. Cetera is under separate ownership from any other named entity. 90 West 100 North STE 6, Price, UT 84501 (435) 637-8160.
The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation.
Distributions from IRAs and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59 ½ may be subject to an additional 10% IRS tax penalty. A Roth IRA offers tax free withdrawals on taxable contributions. To qualify for the tax-free and penalty-free withdrawal of earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Depending on state law Roth IRA distributions may be subject to state taxes.”