The Little-Known Way to Quickly Build a Large Roth IRA

A little-known strategy can help many people quickly generate large Roth IRAs. Some call it the Back Door Roth IRA and others call it the Mega Roth IRA, though both those nicknames also are used for other strategies. Some even call it the Mega Back Door Roth IRA.

Whatever name you want to give it, the strategy avoids two Roth IRA limits that frustrate taxpayers trying to maximize retirement savings. One restriction is the annual Roth IRA contribution limit. The maximum contribution in 2021 is $6,000. You can contribute another $1,000 when you’re age 50 or older, known as a catch-up contribution.

The income ceiling is the other limit. You can’t make an annual contribution to a Roth IRA when your adjusted gross income (AGI) is “too high.” For married couples filing jointly, the contribution limit is reduced when AGI reaches $198,000 and reaches zero at an AGI of $208,000. For individuals, the phaseout begins at AGI of $124,000 and ends when AGI reaches $139,000.

The limits are adjusted for inflation annually. These limits might be avoided when you’re employed and are covered by a 401(k) plan or are self-employed and have a solo 401(k) plan. Either plan needs to have two provisions that most people don’t know about but that most 401(k) plans have.

When your plan has these provisions, you can make after-tax contributions to the 401(k) plan and then roll them over to a Roth IRA. That gives you a Roth IRA that avoids the limits in the tax code.

Most people know that there’s a limit on the tax-deferred contributions (also known as salary deferrals) that can be made to a 401(k) plan. In 2021, that limit is $19,500. An additional $6,500 deferral is allowed for participants aged 50 and older. The deferrals aren’t included in gross income for income tax purposes (though they are included in gross income for determining Social Security and Medicare taxes).

Many people don’t know the tax law allows you to make additional contributions of after-tax income to the 401(k) plan. After reaching the tax-deferred threshold, you can have additional money taken from your salary and deposited in the plan. These additional contributions are included in your gross income for income tax purposes, so you’re contributing after-tax income.

The total limit for 401(k) contributions in 2021 is $58,000, or $64,500 if you’re age 50 or older. That means if you’re younger than 50, you can make after-tax contributions up to $38,500. Ages 50 and older can contribute $37,500 of after-tax contributions. These contributions can fund your Roth IRA. Employer matching contributions are counted in the annual limit per beneficiary.

If your employer makes matching contributions, those will reduce the amount of after-tax contributions you can make. Not all 401(k) plans allow after-tax contributions, but most do. The other provision your plan needs, in addition to allowing after-tax contributions, is to allow in-service distributions without a showing of financial hardship.

The general rule is that you can’t roll over money tax-free from a 401(k) to an IRA or other qualified retirement plan unless you are separated from the service of the employer. Separation from service usually is the result of a job change, retirement, disability, or passing away.

When you aren’t separated from service of the employer, the rollover is treated as a distribution that is included in gross income and possibly subject to the 10% early distribution penalty when you’re under age 59½. But an in-service distribution is one that is allowed, though you continue to work for the employer.

You can have the money rolled over to an IRA, and it will be a tax-free rollover. When you’re 59½ or older the 10% early distribution penalty won’t apply. Many 401(k) plans allow in-service distributions after a minimum age, usually 55. When your plan has these two provisions, you can start accumulating a significant Roth IRA with just a few steps.

Schedule salary deferrals so that you contribute the maximum tax-deferred amount and then have additional after-tax contributions up to either the maximum contribution amount or a lower amount you want to contribute.

Once the after-tax contributions are in the plan, use the in-service distribution option to have them rolled over to your Roth IRA. The 401(k) plan might limit the number of times you can re- quest an in-service distribution during the year.

As a practical matter, the strategy is much smoother when you have the rollover done annually. Don’t take the money out of the 401(k) yourself and contribute it to the Roth IRA. Instead, have the plan administrator make the rollover directly to the IRA custodian. Only the after-tax contributions can be rolled over to the Roth IRA. Any investment earnings have to stay in the 401(k) or be rolled over to a traditional IRA.

You or the plan administrator needs to keep track of these contributions. If you can’t prove the after-tax contributions, you won’t be able to roll over any amount to a Roth IRA. Most 401(k) plans keep track of these separate amounts. Once the rollover is complete, the Roth IRA is treated the same as any other Roth IRA. The account balance can be invested tax free.

Distributions from the Roth IRA, after the five-year waiting period (see our August 2021 issue for details), are tax-free to you. A beneficiary can inherit the Roth IRA and take tax-free distributions. When your 401(k) plan doesn’t allow in-service distributions, you still can execute the plan.

You can make after-tax contributions to the 401(k). The difference is you can’t roll over the money to a Roth IRA until after you separate from service of the employer.

The disadvantage would be that the contributions would have accumulated investment returns. Those compound- ed returns won’t be in the Roth IRA. Eventually, they’ll be taxed as ordinary income when distributed from the 401(k) or a traditional IRA.

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 the strategy also is a way to ensure you have tax diversification and are prepared for whatever changes occur in the tax law.