What Are the Pros and Cons of Mega Backdoor Roth Conversions?

discover the tips and strategies that will help you achieve your retirement goals I'm your host James canole and this is the podcast dedicated to helping you retire well it all starts right here unready for retirement [Music] hi everyone and welcome back to another episode of ready for retirement I'm your host James canole today's episode is going to be about Mega backdoor Roth conversions we'll describe what it is we'll describe where it comes into play and really we'll talk about when does it make sense and when does it make sense when you look at your overall Financial strategy this episode is based upon a listener question and the listener's name is Eric Eric says this he says hi James thank you for your excellent podcast I have successfully been taken advantage of the after-tax contribution slash conversion strategy in parentheses Mega backdoor Roth in my 401k for three years and I've always done this later in the year assuming my plan permits it and I do not exceed the IRS total aggregate contribution limits do you see any reason why I shouldn't execute the strategy early in 2023 if the market is still at lower valuations thank you very much all right Eric well thank you very much for that question excited to go through it today just a quick reminder if you've not already done so already please be sure to leave a review for the ready for retirement podcast you can do so on Spotify and on Apple podcasts allows more people to find the show the more people that find the show the more people that can prepare for a Secure Retirement so share it with your friends your family leave a review please helps the show to keep growing and also be sure to check us out on YouTube under root Financial Partners so back to Eric's question what do we do with megabactor Roth conversions Eric I know one of your questions was the timing of this so I'm going to answer that real quick at the beginning but then I want to flesh out when might this strategy make more sense for other people so Eric what you're saying is you typically do this at the end of the year should you instead do this at the beginning of 2023 if the market is still at lower valuations because then future growth happens in a tax-free account the simple answer is if your cash flow permits it then yes the sooner you can get funds into any account the more likely you are to capture the growth the market provides on an ongoing basis there's no guarantee that the market goes up over the course of 2023 but if you just look at probabilities the sooner you get invested the more likely you are to earn a superior return over time now obviously with a backdoor Roth contribution it takes a good amount of cash flow so for some people it takes doing this throughout the year to to really get funds in if you have a large bonus or if you have large cash flow and can do this sooner rather than later then all else being equal yes take advantage when a market is down for the growth potential going forward it's no guarantee that if the market is still low early next year it will get higher by the end of 2023 but in any year regardless of the Market's low or high in any year there's a positive expected return moving forward so how do we capture that how do we seek to take advantage of that while we get dollars invested as soon as possible so that's the simple and the short answer to part of Eric's question but now I want to look at a more high level because this could apply to Eric this could apply to you this could apply to a large number of people but want to make sure we're looking at this within the proper perspective so to start let's understand the benefits of a mega backdoor Roth conversion the benefits are this once you've maxed out your pre-tax 401K contributions or even before you've maxed these out if you want but certain plans will also allow for what are called after tax contributions with an after-tax contribution you can still add more money to your 401k than the standard limit so there's the employee limit that for 2022 if you're under 50 you can put in 20 500 if you're 50 or older you can put in twenty seven thousand those numbers are going up for 2023. now once you've maxed that out some plans still allow you to do even more through what's called an after-tax contribution when you put money into an after-tax 401K you don't get any tax deductions for the money you put in but as that money grows it grows tax deferred the backdoor conversion aspect of that is you contribute to the after tax 401k and then immediately you're converting those contributions to a Roth 401k here's why you do that let's assume you don't do the conversion aspect of this you just do the after-tax contributions well let's assume you invest 30 000 per year into an after-tax 401k and those dollars will grow by eight percent per year for 10 years after 10 years of doing this you will have about four hundred and thirty five thousand dollars in that account and then let's assume that you retire well when you retire when you leave the company 300 000 of that balance could roll over into a Roth IRA you've already paid taxes on those contributions so those dollars can roll over to a Roth because they're already been taxed so it can roll to an account that grows tax-free while the remaining 135 000 because remember we have 435 000 in this account at this point the remaining 135 000 that would have to roll over into a traditional IRA because that hundred and thirty five thousand dollars is growth and the growth happens tax deferred but not tax-free so when you leave your plan you could roll it into an IRA which again is an account that's tax deferred so it grows tax-free or it's not being taxed as it grows but when you pull funds out of it then you're paying taxes so that's what happens if you just Implement a standard after tax contribution to your 401k all growth is pre-tax unless you convert it right away and this is where the mega backdoor Roth conversion comes into play if as you're contributing that thirty thousand dollars assume you immediately convert it to a Roth I array now when you do this you're not paying any taxes because once again that thirty thousand dollar contribution that we talked about it was made after taxes so taxes have already been paid on that money so if you immediately convert it to a Roth IRA you're not paying taxes because it's already after tax here's the benefit though now as the growth happens if we go back to that eight percent per year growth for 10 years now all that growth is also tax-free so in that instance the entirety of the 435 thousand dollars in that account would be completely tax-free as opposed to only the dollars that you put in so that's the benefit of a mega backdoor Roth conversion strategy it's called Mega because anyone can do this with an IRA or Roth IRA I want to say anyone I mean anyone's eligible but there's some absolute pitfalls you need to be aware of before you do so so it's not advisable for everyone but it is open to everyone but in the standard sense you're limited to six thousand or seven thousand per year because those are the IRA contribution limits this is called Mega backdoor because the after-tax 401K limit is much higher than your limit on Ira contributions so you can do a lot more into a mega backdoor Roth through a 401k than you could through your own Ira or Roth IRA so that's how it works that's the benefit of it now one of the points that Eric made he said something about if it's still available why did he say this well last year new legislation made it seem like this would no longer be an option so build back better proposal that never actually made it through the Senate at the end of 2021 one of the provisions of that legislation was that after tax Ira balances could not be converted to Roth balances what that effectively did was eliminate the ability for people to do backdoor Roth IRAs or Mega backdoor Roth IRAs but build back better did not make it through in the end of 2021 under those Provisions a version of it was passed in 2022 but the section that would have eliminated the conversion of after-tax contributions it was removed from the final legislation which means you can still actually do this now this might be something that continues to be on the chopping block as Congress decides to pass or not pass different things but as of now this is still something that you can absolutely do so what are the reasons to do it versus what are the reasons not to do it well here's when you would do it do it if you're going to invest those dollars anyways and you don't need them prior to age 59 and a half why do I say that well if you're going to invest those dollars anyways the question becomes where can I invest those dollars in the most tax efficient way now by the time that you're doing this most likely you've already maxed out your pre-tax 401K contributions at least most people have either they're pre-tax or their Roth by the time they're doing the after tax contributions it usually means they have pretty good cash flow they're already maxing out the elective deferral amount which for this year again is a 20 500 if you're under 50 or 27 000 if you're 50 or older by the time that you're doing after tax it's likely you've already taken advantage of that so you've probably maxed out your greatest retirement plan option already so for most people the option is do I either take this cash and invest it in a brokerage account or do I invest in my after-tax 401k and then implement the mega backdoor Roth conversion strategy if those are your two options and you're going to invest these dollar is anyways you probably want to do it through your 401k because yes you're not going to tax deduction for the dollars that you put in but you wouldn't get a tax deduction anyways you've already maxed out your 401K limits this is the after tax portion so that's already off the table for most people who are considering this so if we can get all growth to be tax-free that's what we're now looking for and if you invest these funds in a brokerage account so you're not doing it through your 401k but you get your paycheck you pay taxes money shows up in your checking account and then you go to positive brokerage account and invest it from there you're going to pay taxes on the gains on capital gains on interest on dividends versus if you do your mega backdoor Roth you have your paycheck you defer money to the after tax 401K you still don't get a tax deduction there but what you do get is completely tax-free growth from there on out if you successfully execute the backdoor Rock conversion strategy so if you're going to be doing that anyways then yes absolutely keep doing this let's invest for maximum tax benefit because if you're doing the backdoor Roth IRA conversion or if you're doing the mega backdoor Roth conversion chances are good you're in a higher income bracket chances are good you probably have more substantial Savings in your 401k in brokerage accounts in other assets so the need for something that's growing as tax efficiently as possible is likely greater because you might already be in a fairly High tax bracket so if you're going to invest anyways that's the great time to do the mega backdoor Roth IRA you can build up a lot of funds in a tax-free manner for the future again it won't help you at all today it won't save you in taxes at all today but where it will help is in growing tax-free income for the few future when wouldn't you do it well this is where it comes back to your financial plan like I said most people when I work with people that have these options they typically are high earners they're typically people who've already saved and invested quite a bit and so as we're looking at it it's easy to say yeah go fund your mega backdoor Roth IRA but the real questions do you need to I've done episodes before when should you stop saving for retirement at what point do you have enough to be completely fine even if you don't put another dollar away towards retirement if that's you then that's really consider should you do the mega backdoor Roth IRA yes on paper it looks good yes this will grow your after tax or tax-free account balance but what's the trade-off if we've already hit our retirement goals what is the cost of putting more money there what could you instead done not for a greater return on investment standpoint but a better return on life a lot of people I see them saving and saving and saving and it's wonderful but if we don't take a big step back and say what are you doing this for what are the trade-offs you're making by not spending that money today what else could you be doing with these dollars then we don't really have a really well-rounded strategy so does it make Financial sense to do this yes but here's the pushback I give a lot of people do you need to do this are there other things you could use those dollars for is there a family trip you could take is there family support is there giving are there things that would improve your quality of life because at some point in your financial plan things should be viewed let's do the lens of what's going to maximize return and investment and more through the lens of what's going to maximize return on life that's because at some point we have to realize this isn't going to go with us we can keep saving and saving and saving and if you run projections and look at what this means it means great you have a very comfortable retirement and you have more money than you know what to do with by the time it's all said and done if that's your goal then great keep doing that if that's not your goal if your goal is to rather say how can I do as much as I can while I'm here how can I enjoy as much as I can how can I make experiences make memories well that's where this might not be the best thing to do after tax 401k like I said it usually means you've already maxed out your regular 401k contribution limits for most people who are doing this they've already done a great job of saving and investing now if you still need to save more and invest more to get to where you want to go this can be a wonderful tool to help you get there it's for those people who have enough who've done enough who are already there what's the trade-off of doing more of this what is the thing that you want your life to look like what could you be doing with that money today to improve your standard of living versus what could you be doing in the future to improve your standard of living if you're a standard of living in the future is already really high based on what we've already done to who we take a step back and start to focus more on today obviously you can only answer this question for yourself but I know a lot of the people I work with who have options to do this type of a contribution many of them take it in many claims it's an effective tool for them but a lot of them we say we could do this or we could live a little more today and do more today or focus on a different goal today and for them that's a far superior option so I hope this context is helpful there are absolutely Financial benefits to after tax 401K contributions that you then use to implement the mega backdoor Roth conversion strategy but before you do that before you continue doing that just make sure you're looking at the big picture where is every dollar that you earn best utilized for many of us it's a balance between the future and today but how do you understand where that balance is how much should be going towards future goals how much should be going towards things that you want to do today that is what a well-rounded Financial strategy should look like so I hope that was helpful Eric thank you very much for submitting that question thank you to all of you who are listening if you think this episode was helpful or beneficial I'd appreciate you sharing with people who you think could also benefit from it let's make sure that as many people as possible are doing the right thing with their financial planning and with that said I will see you all next time thank you for listening to another episode of the ready for retirement podcast if you're enjoying the show Please Subscribe and let me know by leaving a five star review and as always for a list of the notes and the resources mentioned in today's episode you can find those at the ready for retirement website which is ready for retirement.com that's ready for retirement.co and if you have a question that you would like for me to answer in a future episode then you can also go to the ready for retirement website ready for retirement.com there's a page called submit your question where you can submit a question for me to answer in a future episode thanks as always for listening and I'll see you next time thank you

Channel: James Conole, CFP®

Views: 26,980

Keywords: investing, retirement planning, tax planning, financial planning, retirement, personalfinance, taxes, dividend investing, financial planning at 50, how do I retire?, long-term investing, financial planning at 60, roth conversions, roth ira, IRA, individual retirement account, benefits of investing, pros and cons of investing, donor advised fund, financial education

Id: SEA87cLNaQc

Length: 15min 51sec (951 seconds)

Published: Tue Nov 22 2022