Higher-income taxpayers often are shut out of the benefits of a Roth IRA.
Contributions can be made to a Roth IRA only when your adjusted gross income (AGI) is be-low a certain level: $193,000 for a married couple filing jointly in 2019 and $122,000 for a single taxpayer. When AGI is above that level, the maximum contribution to a Roth IRA is gradually reduced until it is phased out at AGI of $203,000 for marrieds filing jointly and $137,000 for singles.
Most people believe the only other way to establish a Roth IRA is to convert all or part of a traditional IRA to a Roth. Many people don’t want to do that, because they don’t want to pay the taxes that are due on the conversion. So, they do without a Roth IRA.
I encourage most people to have a portion of their assets in a Roth IRA so they’ll
enjoy the benefits of tax diversification. See our April 2018 issue for details of tax diversification.
There’s another way to funnel money into a Roth IRA. It allows you to con-tribute far more than is allowed through regular Roth IRA contributions. It’s especially valuable for high-income taxpayers who are still working and for the self-employed.
The strategy is known generally as the Mega Backdoor Roth IRA. The Mega Backdoor Roth IRA begins with an employer 401(k) plan. If you’re self-employed, you can set up a single-member 401(k) plan.
Most people are familiar with the annual limit on tax-deferred 401(k) contributions, which is $19,000 in 2019. You designate a portion of your salary to be deferred into your 401(k) account. The deferred amounts up to the limit are excluded from gross income for income tax purposes, but not for Social Security and Medicare tax purposes. Those are the pre-tax contributions to your 401(k).
Not as many people know the tax code allows additional contributions to the 401(k) account.
These additional contributions are after-tax contributions, because there’s no tax deferral. The additional amounts you defer are included in gross income and are fully taxed. When you eventually withdraw them, the after-tax contributions won’t be taxed. The after-tax contributions are invested in the account, and the in-come and gains compound tax deferred. The income and gains are taxed as ordinary income when they are distributed.
The tax code allows total 401(k) contributions of $56,000 in 2019. (The limits are adjusted for inflation each year.) That means you might be able to make up to $37,000 of after-tax contributions.
If your 401(k) plan makes matching contributions, the matching contributions count against your annual limit. So, you might not be able to set aside the full $37,000 of after-tax contributions.
Not all 401(k) plans allow after-tax contributions, but most do. Check with your plan administrator to see if after-tax contributions are allowed under your plan. If they aren’t, ask if the plan can be amended to allow them.
Next, see if your plan allows in-service distributions without a showing of financial hardship.
Normally, 401(k) distributions can only be made due to separation from the employer, death, disability or financial hardship. But distributions also can be made after age 59½ for any reason with-out a penalty, if the plan allows it. These are called in-service distributions, because you’re still working for the employer.
When these two conditions are in place, you make after-tax contributions to the 401(k) and use an in-service distribution to roll it over to a Roth IRA. Once the funds are in the Roth IRA, they are treated the same as other Roth IRA money. Income and gains compound tax-free in the Roth IRA. There are no required minimum distributions (RMDs) during your lifetime. Any beneficiary who inherits the IRA must take RMDs during his or
If the plan doesn’t allow in-service distributions, you still can roll over the funds to a Roth IRA, but not until you retire or otherwise leave the employer. Then, you have to roll over the entire 401(k) account to IRAs.
The after-tax funds would go to a Roth IRA and the rest of the account would go to a traditional IRA. Earnings and gains in the 401(k) can’t be rolled over to the Roth IRA. Remember, only after-tax contributions can be rolled into a Roth IRA.
You or the plan needs to keep track of these contributions. If you can’t prove these amounts, you won’t be able to roll over any amount to a Roth IRA. Most 401(k) plans keep track of these separate amounts. The Mega Backdoor Roth IRA is particularly attractive when you believe tax rates are likely to be higher in the future.
You can pay taxes at today’s rates (which were decreased in the Tax Cuts and Jobs Act in 2017) and ensure the money and the earnings on it will be tax free when you take them out of the Roth IRA. But it’s also a way to ensure you have tax diversification and are prepared for whatever changes occur in the tax law.
To use this strategy, see if your 401(k) plan allows after-contributions. If it does, decide how much you want to contribute and set up the additional contributions. See if your plan allows in-service distributions.
If it does and you’re eligible to make them without penalties, you can roll over those after-tax contributions to a Roth IRA. An annual rollover should be fine. If you can’t take in-service distributions, the rollover to the Roth IRA can wait until you leave the employer, either for retirement or another job.