Mega Roth IRAs Explained
Published on January 13, 2022
A mega Roth IRA and the related mega backdoor Roth IRA conversion comprise a strategy to build retirement wealth with a supersizing feature (the “mega” part). Taxpayers must meet certain income eligibility requirements for contributing to a Roth IRA and the mega backdoor IRA became a way for high-net-worth or highly compensated employees to do so, through a Roth conversion.
Roth conversions – the foundation of the mega Roth IRA strategy
Doing a Roth conversion (rolling over funds from a Traditional IRA into a Roth IRA) is the basis for the mega Roth IRA strategy.
A Roth conversion occurs when the taxpayer converts pre-tax money in a Traditional IRA (funds that will be taxed upon distribution from that retirement account) into after-tax money in a Roth (since funds are taxed going into the Roth IRA and are withdrawn tax free).
Account owners may opt to convert some portion of their existing Traditional IRA to a Roth IRA every year (depending on the account balance and one’s overall financial picture). You will likely pay some taxes on the money that’s rolled over. This may make financial sense based on prevailing tax rates that year or your income.
As always, we recommend you consult with your CPA or tax advisor about executing this type of transaction, as well as determining which account will cover the tax payments (to maximize what is in the Roth IRA).
Backdoor Roth IRA
Money that is rolled over to a Roth IRA can also be from an employer-sponsored retirement plan into a Roth IRA or the plan’s Roth “bucket.” This generally involves 401(k) plans (including self-directed solo 401(k)s).
Taxpayers who build wealth through the figurative backdoor generally have income that is too high to qualify for making annual contributions to a Roth IRA or take advantage of the deductibility of Traditional IRA contributions. Even so, there are ways to shift money to the Roth IRA with the potential for tax-free withdrawals later.
Participants in a 401(k) can put up to $20,500 (or $27,000 for those over age 50) into their account. The employer may make matching or flat contributions to the employee’s account. This can be done on either on a Traditional or Roth basis. Some employers also offer the Roth 401(k) option so the employee’s contributions can be made with post-tax money and grow tax free.
The Roth conversion can be for any amount of money but again, since it could trigger a taxable event, account owners should consult their trusted advisor before doing so.
The Mega Backdoor Roth IRA
The mega backdoor Roth IRA occurs when the 401(k) participant:
- a) makes an extra non-deductible, after-tax voluntary contribution to the plan (up to the maximum annual limit), and;
- b) converts that amount to the Roth IRA or keeps it in the plan’s Roth portion.
It also requires that:
- a) the plan design offers this feature to add after-tax contributions to the 401(k);
- b) the plan allows either an in-plan Roth conversion (employee’s after-tax contributions are rolled into the plan’s Roth bucket), or;
- c) the employee is permitted to roll the funds out of the plan into a Roth IRA.
How is “Mega” Status Achieved?
If the employer plan offers the option, eligible taxpayers can put away up to $40,500 in after-tax dollars in a Roth IRA or a Roth 401(k) in 2022. This amount is on top of the regular 401(k) contribution limits of $20,500/$27,000 this calendar year. That means a total contribution of $61,000-$67,500 (depending on age) in 2022.
These additional voluntary contributions can be made each year, with an annual Roth conversion.
Beware: Mega Roth IRAs May Be in Danger
Some investors have notably created portfolios valued in the hundreds of millions or billions through their mega backdoor Roth IRAs. This wealth-building strategy for very high-net-worth individuals caught the attention of federal legislators last year as they crafted the Build Back Better (BBB) Act. BBB has a provision to:
- Limit the size of these tax-free investment portfolios
- Require minimum distributions regardless of the account owner’s age
- Prohibit the transfer of after-tax assets starting this year
- Cap high-income taxpayers’ aggregate retirement account balances in 2029
- Prohibit backdoor IRA and 401(k) conversions into Roth accounts after 2031
However, when the BBB Act stalled in Congress, President Biden announced last month that the U.S. Senate will take it up again in 2022, so for now, the mega backdoor Roth strategy is still in play. Therefore, solo 401(k) taxpayers can still make voluntary after-tax contributions in 2022 for the 2022 tax year and subsequently convert the contribution to a Roth IRA or the Roth solo 401(k) in 2022.
Self-directed Roth IRAs (of any size) at Next Generation
If you have a self-directed Traditional IRA, the same rules apply if you wish to convert some of those funds into after-tax dollars by converting funds into a self-directed Roth IRA. As the administrator and custodian of self-directed retirement plans, Next Generation will issue Form 1099-R to the IRS to report the conversion from Traditional IRA to Roth IRA or from the solo 401(k) to the plan’s Roth IRA feature. Our team also manages all the account paperwork and required reporting for our clients’ plans.
While we do not provide investment advice, our team does provide client education about the many aspects of self-direction as a retirement strategy. This includes answers to your questions about Roth conversions and the types of alternative assets allowed through self-direction. You may schedule a complimentary educational session, or contact our team directly at NewAccounts@NextGenerationTrust.com or 888-857-8058.