The Mega Backdoor Roth Conversion
How to get more than 7x as much into your tax-free retirement account.
As many of you already know, the 2021 Roth IRA contribution limit was $6,000 for those under the age of 50 and $7,000 for those over 50 who can take advantage of catch-up contributions.
In this post, we will go into a step-by-step example of how our clients are putting away more than 7x that amount. With the tax and estate benefits of Roth dollars being so significant, these dollars are some of the most valuable in a client’s portfolio.
Roth dollars are taxed at your regular income limit just like dollars in your checking, saving, or brokerage account but with one major difference. Any growth on these Roth Dollars are tax-FREE, as long as you wait until retirement age (59.5) to access them.
The one key to being able to use this strategy is having a retirement plan with an after-tax election option. This is not a new strategy but it is something we often have to vouch for on behalf of clients.
We’ll use an example of a 45-year-old physician with an annual income of $400,000 and how they can take advantage of all their eligible tax-advantaged accounts if their goal was to minimize tax-free retirement dollars.
Think of this cash flow like a waterfall and each bucket should be filled up in this order to maximize the tax advantages. Keep in mind this may not be the same for everyone but is a good example for someone who wants to minimize their tax liability in retirement:
Maximum Roth IRA Contributions of $6,000
Employee Contribution of $19,500
After-Tax Contribution of $38,500 (Yes, that’s right, you can contribute that much)
This highlights the true 401(k) limit for 2021 which is $58,000. This number includes employee contributions, employer contributions (match and profit sharing), as well as the after-tax contributions you are eligible to make.
Now, if you stop here, you’ve done a great job saving in your retirement account but you are one key step away from maximizing the tax benefits. Those after-tax dollars are eligible to be converted to your Roth IRA. This does not affect your eligibility to make normal Roth IRA contributions in any way.
That means you have contributed $45,500 into your Roth IRA in one year! An over 758% increase in your tax-free retirement dollars!!
Assuming you did this every year for 30 years and saw your investments grow by 8% every year, your tax-free Roth IRA would have accumulated $5,569,005. The Employee Contributions you made into your 401(k) would have grown into $2,865,890. Now we do not know what the tax code is going to look like in 30 years, so we generally recommend a blend of money types for each client so they can optimize their retirement draw-down in retirement.
For this example, we are looking to maximize tax-free dollars and are able to have this client retiring in 30 years with $8,434,895 and NO TAX LIABILITY.
Does your retirement plan have Roth and after-tax contributions available? If so, make sure you are reviewing your cash flow, savings rate, and investing rate to see if it makes sense for you to take advantage.
If they don’t, it is probably worth an email to your HR department to see what it would take to have these added.