We’ve noticed a consistent theme of people focusing on reducing taxes now rather than planning for tax flexibility during retirement. While focusing on lowering taxes now is crucial, considering strategies for tax-free distributions in retirement is equally important.

The Backdoor Roth IRA and Mega Backdoor Roth are two powerful strategies that enable individuals to maximize the total amount they can contribute annually into tax-free Roth accounts. Thus, they add a tremendous amount of flexibility to help control how much tax they pay in retirement.

Backdoor Roth IRA

The term Backdoor Roth IRA is commonly used to describe the process for high-income earners to contribute to their Roth IRA. The IRS imposes income limitations on Roth IRA contributions, with individual tax filers earning more than $161,000 or Married Filing Joint filers earning more than $240,000 phased out of making standard contributions (2024 income limits).

As a result, high-income individuals and couples who exceed these thresholds must follow a two-step process to fund their Roth IRAs. First, they make a non-deductible IRA contribution and subsequently convert it to their Roth IRA. Since the IRA contribution was not claimed as a deduction and the conversion happens before any appreciation occurs, this is a non-taxable event. The contribution limit for this strategy aligns with the annual IRA/Roth IRA limits: $7,000 + $1,000 catch-up for anyone over age 50 (2024 limits).

However, this strategy does not work well if you have current balances in a Traditional IRA, Simple IRA, or SEP IRA, as the IRS views these assets as part of the IRA aggregation calculation, potentially triggering taxable events. To avoid taxes being triggered, it is recommended to have a $0 balance in any pre-tax IRA account type.

Mega Backdoor Roth

The Mega Backdoor Roth, while less known than the Backdoor Roth IRA, follows a similar principle but it applies to your 401(k) or 403(b). To implement this strategy, you should first maximize the employee contribution of your 401(k) with a $23,000 + $7,500 catch-up if you’re over age 50 (2024 limits). The total IRS cap on 401(k) contributions between employer and employee contributions is $69,000 (or $76,500 if over age 50). If your employer match or profit sharing is less than $46,000, you can contribute the remaining amount as an after-tax contribution and subsequently convert that after-tax balance to your Roth.

Example

Consider John, age 45, is maximizing his 401(k) with $23,000, and his total employer contribution is $16,000. John could contribute $30,000 as an after-tax contribution and then convert it to his Roth. However, this strategy is contingent on several factors:

• You must participate in a 401(k) or 403(b) plan.
• Your plan document must allow “after-tax contributions.”
• Your plan must also allow you to move money from your after-tax portion into your Roth portion (or allow you to take in-service distributions from your after-tax portion and roll these into your Roth IRA).
• You must have the cashflows to support this level of contributions.

If you’re unsure whether your plan allows these steps, contact your Human Resources department or 401(k) plan administrator.

Order of funding

To optimize your tax-free contributions, here is the commonly followed order of funding:

1. Max your employer-sponsored plan (plus catch-up if applicable)
2. Max Backdoor Roth IRA
3. Max Mega Backdoor Roth through an employer-sponsored plan
4. Any excess cashflows can be invested in a taxable investment account

Roth accounts grow tax-free, and distributions can be taken tax-free as long as the accounts meet the criteria for qualified distributions. Roth IRA distributions do not count as Modified Adjusted Gross Income (MAGI), offering added flexibility around Medicare premiums and taxation of other benefits. Due to the potential tax pitfalls if not executed correctly, we advise individuals to consult their CPA and financial advisor for comprehensive tax planning.

Consult With a Lutz Financial Advisor

Lutz Financial's advisors collaborate with our in-house tax planning experts to develop a retirement strategy that works best for you. If you have any questions or would like to set up a consultation, please contact us.

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