Mega Backdoor Roth: $55K Tax-Advantaged Contribution Annually

Mega Backdoor Roth: $55K Tax-Advantaged Contribution Annually

Executive Summary

High-income individuals often face limitations in contributing to traditional retirement accounts. This case study highlights how Golden Door Asset helped a client overcome these limitations by implementing a mega backdoor Roth strategy. By enabling after-tax 401(k) contributions and subsequent conversion to a Roth IRA, we facilitated an additional $55,000 in tax-advantaged retirement savings annually, significantly enhancing their financial security.

The Challenge

Our client, a 48-year-old executive earning $450,000 annually, faced a common dilemma for high-income earners: limitations on contributing directly to a Roth IRA and deductibility restrictions on traditional IRA contributions. While maximizing contributions to their employer-sponsored 401(k) at $22,500 per year (plus a $7,500 catch-up contribution), they felt constrained in their ability to further bolster their retirement savings. They were also concerned about the potential tax burden on their estate, projected to exceed $15 million. Direct Roth IRA contributions were not an option due to their income exceeding the limit for single filers. Traditional IRA contributions would not be fully deductible either, further limiting their ability to effectively reduce their tax burden. The client expressed concern about missing out on the benefits of tax-free growth within a Roth IRA, especially given their long investment horizon of approximately 20 years until retirement. They sought a solution that would allow them to maximize their retirement savings in a tax-advantaged manner, while also mitigating future estate tax liabilities. Furthermore, they were wary of the complexity involved in managing after-tax contributions and conversions, and desired a streamlined process to ensure compliance and minimize errors.

The Approach

Golden Door Asset recognized the client's suitability for a mega backdoor Roth strategy, which involves contributing after-tax dollars to a 401(k) plan that allows for in-service distributions and subsequent conversion of these contributions to a Roth IRA. Our approach encompassed several key steps:

1. Plan Eligibility Assessment: We thoroughly reviewed the client's employer-sponsored 401(k) plan document to confirm that it permitted after-tax contributions and in-service distributions or rollovers. This is a critical first step, as not all 401(k) plans offer these features. We specifically looked for provisions allowing for non-Roth after-tax contributions that can be distributed.

2. Contribution Strategy: We developed a contribution strategy tailored to the client's financial situation. The IRS limit for total 401(k) contributions (employer + employee) in 2023 was $66,000. Factoring in the client's existing pre-tax contributions of $30,000 ($22,500 employee + $7,500 catch-up), this left a potential for $36,000 in after-tax contributions. This limit is then adjusted for cost of living each year, but this figure remained constant for the purposes of this example.

3. Coordination with Employer: We collaborated closely with the client's HR department and retirement plan administrator to ensure seamless implementation of the strategy. This involved educating the employer about the mega backdoor Roth and confirming the proper coding and reporting of after-tax contributions. We confirmed the availability and process for initiating in-service rollovers of the after-tax contributions.

4. Conversion Process: We established a systematic process for converting the after-tax 401(k) contributions to a Roth IRA. This typically involves requesting a direct rollover from the 401(k) to a Roth IRA. We emphasized the importance of completing the conversion promptly to minimize any potential taxable gains on the after-tax contributions before conversion.

5. Tax Planning & Compliance: We integrated the mega backdoor Roth strategy into the client's overall tax plan, ensuring accurate reporting on Form 8606 (Nondeductible IRAs) and providing ongoing guidance to maintain compliance. We analyzed the client's overall tax bracket to determine if the tax-free growth of a Roth IRA would be more beneficial than the immediate tax deduction provided by a traditional IRA, considering factors like expected future income and potential changes in tax laws.

Technical Implementation

Implementing the mega backdoor Roth required precise coordination and attention to detail.

• 401(k) Plan Audit: We conducted a thorough audit of the client's 401(k) plan documents, paying close attention to the definition of "eligible rollover distribution" and confirming the availability of in-service withdrawals or rollovers of after-tax contributions.

• Contribution Tracking: We established a system to meticulously track the client's after-tax contributions, ensuring that they did not exceed the IRS limit. This involved monitoring both employee contributions and any employer matching or profit-sharing contributions. We also tracked the basis (the original after-tax amount) to ensure accurate reporting during the conversion process.

• Rollover Procedures: We worked with the plan administrator to streamline the rollover process. We established a consistent schedule for initiating rollovers, typically on a quarterly basis, to minimize the potential for taxable earnings within the after-tax 401(k) account.

• Form 8606 Management: We assisted the client in completing Form 8606 accurately, reporting the nondeductible contributions and the subsequent Roth IRA conversions. We carefully calculated the taxable portion of the conversion, if any, based on the pro-rata rule, which applies if the client also has pre-tax balances in traditional IRAs.

• Integration with Financial Planning Software: We integrated the mega backdoor Roth strategy into the client's financial plan using our proprietary AI-powered planning tools. This allowed us to model the long-term impact of the strategy on their retirement savings and estate planning goals. The system forecasts the benefit of the Roth contributions based on estimated growth, tax implications, and time to retirement to illustrate the projected value.

Results & ROI

The implementation of the mega backdoor Roth strategy yielded significant benefits for the client:

• Increased Retirement Savings: The client was able to contribute an additional $36,000 annually to their retirement savings beyond their pre-tax 401(k) contributions. This amounts to a potential $720,000 over 20 years, assuming consistent contribution amounts.

• Tax-Free Growth: By converting the after-tax contributions to a Roth IRA, the client's savings will grow tax-free, and withdrawals in retirement will also be tax-free. Assuming an average annual investment return of 7%, the Roth IRA balance could reach approximately $1.4 million after 20 years, all tax-free. This contrasts with the potentially significant tax liabilities associated with distributions from a traditional 401(k).

• Estate Tax Mitigation: The Roth IRA assets are not subject to income tax upon distribution, which can help reduce the overall tax burden on the client's estate. This offers a significant advantage compared to traditional retirement accounts, where distributions are subject to income tax.

• Reduced Taxable Income: Although the after-tax contributions are not tax-deductible, the tax-free growth and withdrawals from the Roth IRA can result in lower overall taxable income in retirement. By moving taxable dollars into a tax-exempt structure, the overall tax burden on the client’s total assets decreases in the long run.

• Streamlined Process: Golden Door Asset's expertise and coordination ensured a seamless and compliant implementation of the mega backdoor Roth strategy, saving the client time and minimizing the risk of errors.

Key Takeaways

1. Assess Plan Eligibility: Thoroughly review 401(k) plan documents to confirm the availability of after-tax contributions and in-service distributions or rollovers.
2. Coordinate with Stakeholders: Collaborate with HR departments and retirement plan administrators to ensure seamless implementation and proper reporting of after-tax contributions.
3. Establish a Systematic Process: Develop a streamlined process for converting after-tax contributions to a Roth IRA on a regular basis to minimize taxable gains.
4. Integrate into Financial Planning: Incorporate the mega backdoor Roth strategy into the client's overall financial plan to model the long-term impact on retirement savings and estate planning goals.
5. Emphasize Tax Compliance: Provide ongoing guidance to clients to ensure accurate reporting on Form 8606 and maintain compliance with IRS regulations.

About Golden Door Asset

Golden Door Asset builds AI-powered intelligence tools for RIAs. Our platform helps advisors unlock advanced planning strategies, automate complex calculations, and deliver personalized advice at scale. Visit our tools to see how we can help your practice.