You may have heard this bizarre sounding term "Mega backdoor Roth" pop up in financial articles or amongst conversations with colleagues which seems more related to furniture than finance. We’re here to break it down. We’ll start with what’s a “Roth,” then what does “backdoor” mean, and how much is “mega.”

Roth IRAs (Individual Retirement Accounts) are, as in the name, accounts earmarked towards retirement. The term Roth itself is named after the US Senator William Roth who sought to increase people’s access to utilizing IRAs, therefore saving more for retirement. There are two types of IRA accounts: Traditional IRAs and Roth IRAs. What makes Roth IRAs notable and a great way to save for retirement is that the investment earnings are tax-free. This is a big advantage when it comes time to take money out of the account, no taxes are owed. The IRS allows these Roth dollars to grow tax-free but restricts it by both who can contribute (based on your income) and the yearly contribution amount. For example, in 2024, the maximum contribution is $7,000 per person ($8,000 if age 50 or older) and you must make under $161,000 (modified adjusted gross income) if you file single, or under $240,000 if you file married jointly, in order to contribute.¹ These income and contribution limits on Roth accounts may make it challenging to build up a large enough Roth IRA to cover your retirement needs. That’s where the backdoor option comes in.

The "backdoor" is a strategy for people whose income is too high to be eligible for regular Roth IRA contributions. The term backdoor comes from the idea that high earners are side-stepping the Roth IRA income limits by converting traditional 401(k) or IRA contributions into a Roth 401(k) or Roth IRA. There is no income restriction or conversion limit. In doing so, you will, however, pay income tax, as Roth money is after-tax, so you'll want to be prepared to pay taxes. But, again, the advantage of doing this is that the money in a Roth grows tax-free, so while you will pay taxes upfront for the contribution, once the funds are in a Roth 401(k) or IRA, the money grows tax-free, providing you with tax-free income in retirement. Your future self will thank you!

Now how much is "Mega?" In 2024, the amount someone can contribute to a Roth IRA via the mega backdoor strategy is up to $46,000.¹ This is quite a lot more than the $7,000 that one can contribute directly to a Roth, hence the term "mega." In practice, what this looks like is after contributing the maximum to your regular 401(k) ($23,000 in 2024), if you'd like to contribute additional funds and your employer plan allows for after-tax contributions, you can make after-tax 401(k) contributions into a Roth 401(k) or Roth IRA. Not all 401(k) plans allow distributions to a Roth IRA, so this strategy may have to wait until you leave the company or retire. Without this strategy, the most one can contribute to their 401(k) in 2024 is $23,000. With after-tax contributions, you may be able to increase the total amount to $69,000.²

If you're finding yourself in the financial position where you are above the income limits to be able to contribute directly to a Roth IRA and you are looking for additional ways to save money for retirement, the Mega backdoor Roth strategy is one you should discuss with a financial advisor. Reach out to us at Cable Hill Partners if you'd like to discuss whether this strategy makes sense for you in context of your other financial goals.

Sources:

1 IRS: https://www.irs.gov/newsroom/401k-limit-increases-to-23000-for-2024-ira-limit-rises-to-7000#:~:text=Highlights%20of%20changes%20for%202024,to%20%247%2C000%2C%20up%20from%20%246%2C500.

2 Fidelity: https://www.fidelity.com/learning-center/smart-money/401k-contribution-limits