If you are exploring ways to maximize retirement savings beyond the traditional 401(k), IRA, and HSA contributions, consider the following strategies utilizing a Roth IRA.
For those individuals with high levels of income, contributing directly to a Roth IRA is not an option. For 2019, individuals are phased out of making Roth IRA contributions when income exceeds $203,000 for married filing jointly taxpayers and $137,000 for single taxpayers. Fortunately, there are indirect ways to contribute to a Roth IRA.
Why should one consider contributing to a Roth IRA? Roth IRAs allow earnings to grow tax-free and are not subject to the required minimum distribution rules; i.e., mandatory distribution at age 70½. Thus, Roth IRAs provide a way to transfer more money to heirs if cash is not needed in retirement.
One strategy for contributing money to a Roth IRA is called the “Backdoor Roth IRA.” It requires a nondeductible contribution to a Traditional IRA that is then converted to a Roth IRA. The maximum contribution permitted is $6,000 (and $7,000 for those ages 50 and older). To avoid issues, any Traditional IRAs, SEP IRAs, or SIMPLE IRAs that are not being converted into Roth IRAs should be eliminated. The “Backdoor Roth IRA” provides a way of getting money into a Roth IRA.
If you have the cash flow and are looking to put even more money into a Roth IRA, you should use the “Mega Backdoor Roth” strategy. This encompasses making after-tax 401(k) contributions and rolling them into a Roth IRA. In order to utilize this strategy, your employer must allow after-tax contributions and for best results, your employer must also allow in-service withdrawals so that these after-tax contributions can be rolled over immediately to minimize earnings.
By way of background, there are three types of 401(k) contributions: pre-tax, Roth, and after-tax. Pre-tax contributions reduce current taxable income and are taxable, along with earnings, when withdrawn. Roth contributions are made post-tax and earnings are not taxed upon withdrawal. After-tax contributions are also made post-tax but earnings are taxable when withdrawn. The “Mega Backdoor Roth” utilizes after-tax contributions and does not utilize Roth contributions.
To illustrate, for 2019, the maximum amount that can be added to a participant’s retirement account is $56,000, not including catch-up contributions. This annual limit includes participant contributions (pre-tax or Roth), employer contributions, such as a match, and forfeitures. An individual who is 55 years old, made $25,000 of pre-tax contributions ($19,000 of pretax plus $6,000 of catch-up contributions) and received $6,000 in an employer match, could possibly make up to $31,000 in after-tax contributions. The $31,000 can be withdrawn immediately and rolled into a Roth IRA if the plan provides for in-service withdrawals. Pre-tax or Roth contributions must be maxed out before after-tax contributions can be made. However, be aware that non-discrimination rules apply which may limit the amount of allowable after-tax contributions.
As mentioned above, once the after-tax contributions are made, they can be rolled into a Roth IRA if the plan allows for in-service withdrawals. Otherwise, the withdrawal needs to wait until termination at which point any earnings on the after-tax contributions are taxable.
Depending on how much cash you have, one of these strategies can be employed to put either a small or large amount into a Roth IRA and transfer more wealth to heirs.
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