Is the mega backdoor Roth right for you?

When you envision your retirement, what does it look like? Will your monthly expenses go up or down from when you were working? Will you stay in your home, downsize to a new city or travel full time? Once you have a clear picture of your retirement goals, the next step is ensuring your savings strategy aligns with that vision, especially when it comes to maximizing tax-advantaged accounts.

If you are a high-income individual, you may not be able to contribute to a Roth IRA because of your federal individual income tax filing status and your adjusted gross income limits. Or, you may have already maxed out your elective deferral contributions to your 401(a), 401(k) or 403(b) plan under the IRS annual deferral limit. If that applies to you, you may be able to use a mega backdoor Roth to convert additional retirement savings into a Roth retirement account.

The mega backdoor Roth strategy enables high-income individuals to contribute significantly more to Roth retirement accounts than the IRS annual deferral limits allow. This approach utilizes after-tax contributions to employer-sponsored 401(a), 401(k) or 403(b) plans, which are then converted into Roth accounts within that plan.

Here’s how a mega backdoor Roth works, how you can do it, and who benefits from it

First, the employer-sponsored plan must permit non-Roth after-tax contributions. Under this plan, a participant makes non-Roth after-tax contributions, meaning these contributions are made to the plan on an after-tax basis. These non-Roth after-tax contributions — together with all employee contributions (other than any age-based catch-up contribution), employer contributions, and forfeiture allocations to the participant’s account — are capped by the annual contribution limit set by the IRS. For information on the IRS 415 annual limit, please visit the Voya IRS contribution limits page.

If elected by the participant, once the after-tax money is contributed, it can then be converted to a Roth account within the plan. One caveat is that the employer-sponsored plan needs to permit an in-plan Roth conversion account (some plans don’t offer that feature). Any earnings on the after-tax contributions that are converted to Roth will be subject to ordinary income tax at the time of the conversion.

The amount converted also remains subject to the distribution rules applicable to the original contribution source. Often, after-tax sources are eligible for distribution at any time, depending on your plan. Once the after-tax is converted to Roth, it then takes on the taxation characteristics of a Roth account. When the Roth account is distributed, federal income tax will apply to the attributable earnings if the distribution is not qualified, and potentially an IRS 10% premature distribution penalty tax unless you meet an exception.¹ To be a qualified distribution, generally, the Roth account has to have been maintained for at least 5 years and you must be at least age 59½, disabled or have payments made to your beneficiary upon your death.

Who is eligible?

Your employer-sponsored plan will need to permit in-plan Roth conversions and non-Roth after-tax contributions. In addition, if the employer sponsoring the plan is not a governmental entity, then your non-Roth after-tax contributions to that plan might be limited by IRS nondiscrimination testing, which ensures that plans aren’t more beneficial to higher earners.

Your next move

The mega backdoor Roth strategy might be a good consideration for high earners, whether it’s an individual with a high yearly salary, or someone who has received a significant bonus at work. It could also be a useful tool for someone who has received a windfall of cash outside of their job — an inheritance, for example — and who can then forgo their salary by putting it toward retirement.

A mega backdoor Roth can be a complicated process, so it’s important that you work with tax and financial professionals to help avoid any issues. They will be able to update you on any changes to the tax code and ensure you file the correct paperwork.

If you are still not sure if a mega backdoor Roth is right for you, talk to a financial professional about whether it might be helpful for your needs and goals.