[00:00:00] Speaker A: In this episode, we tell you about a strategy that some super saving high income earners use to skirt the requirements typically associated with Roth retirement accounts. It's called the mega Backdoor Roth Conversion.
[00:00:10] Speaker B: Let's get started from new Money new problems. It's the New Money New Problems podcast, a show for successful professionals searching for the tools they need to navigate financial opportunities and obstacles they've never seen.
Negotiating compensation, purchasing your first investment property. Helping your family with money. The highs and lows of, uh, entrepreneurship. New money brings new problems that require new solutions. Join us as we work through them together.
I'm Brenton Harrison, and this is the New Money New Problems podcast.
[00:00:50] Speaker A: Hello. My name is Brenton Harrison of New Money New Problems and your host for the New Money New Problems podcast. If you joined us over the last few episodes, you know that we've been covering employee benefits that you can take advantage of as a high income earner, as it is open enrollment, the time of the year that people pick the employee benefits that they plan to use over the upcoming twelve months. In the most recent episode, we talked about some of the benefits specifically associated with high income earners. Things like Roth 401 Ks and 403 B's, 457 plans, and all these different tips and tricks that you can use to take advantage of the fact that you're in a position where maybe you can save more than the typical person at your employer. We teased out in that episode a strategy called a mega backdoor Roth conversion. And this is something that people use as high income earners to put themselves in a position where they can establish retirement funds on which they've already paid taxes so that they don't have to pay taxes on it when they withdraw in retirement. To explain the benefit of that, let's go back to our, uh, lessons on pretax or traditional contributions as compared to Roth contributions. When you have a pretax or traditional retirement account, you're putting aside money that you have not paid income tax on yet, and by doing so, you're reducing your taxable income. An example would be, if you make $100,000 and you put $5,000 into a pretax retirement account, you have lowered your taxable income by that $5,000. You are kicking the can on paying taxes on those dollars. Now, if you put that into that account and it grows tax deferred throughout the years, let's say that over the course of time, your account in that pretax account grows to a million dollars. Well, when you withdraw those funds, every withdrawal you take is taxed as ordinary income. So if, for example, in the first year of your retirement, you withdraw $30,000, it would look as if you earned that $30,000. Roth retirements are the opposite. They're the other end of the spectrum. You're putting aside dollars that have already been taxed. So in our example, you make $100,000, you put aside $5,000 in a Roth retirement account, you have not reduced your taxable income. You will pay income tax on that 5000. But now, if that Roth account grows to a million dollars, and in the first year you withdraw $30,000, you don't pay any income taxes on those funds. And as a result, there are people of all income levels who love the concept of Roth retirement accounts, not just because of the ability to get the income taxes out of the way, but there are several other features associated with them that we'll cover in detail on future episodes. But today we're going to talk about a particular strategy called the Mega Backdoor Roth Conversion, which takes place in your 401K plans through your employer. And the first thing to understand about mega backdoor Roth conversions is why a person would do it in the first place. What's the point of doing all these machinations if you could just put the money directly into an account? Why wouldn't you do that instead? Well, it's because for various reasons, you can't put the amount of money that would go into a mega backdoor Roth directly in an account. Now, let's go through some of those reasons. If you're following along with us on screen, we're going back to the tax tables that we've reviewed in our past couple of episodes. And I want to point your attention to a phrase that says, Roth phase out. And you'll see a phase out range for individuals that file as a single person of 138,000 to 153,000 married, filing jointly, 218,000 to 228,000. What this is saying is if you have a modified adjusted gross income above these levels, you cannot even contribute to a Roth IRA. You earn too much money to do so. So you might then say, if you were paying attention to the most recent episodes, why wouldn't they just put it in their Roth 401K? Because, as we covered recently, there are no income limits associated with the Roth. Four hundred and one K. You can contribute to this account no matter how much you earn. But even though you can contribute, you are still subject to the contribution limits as set each year by the IRS in the year 2023. You can see on screen that the contribution limits associated with 401 B's and 457 plans is $22,500. Now, that's a lot of money, but we're talking in this episode about people who have more than that, far more than that, that they want to contribute to their retirement accounts, specifically their Roth accounts. So if we have a person who makes too much to go into a Roth IRA and they can contribute to a Roth 401K, but they want to go above the $22,500, what would they do next? They would potentially go to the mega backdoor Roth conversion. So if you want to pursue this strategy, what are the steps associated with it? Well, the first step is to ask if your employer allows for after tax contributions to their 401K plan. We talked about these contributions in our most recent episode, but we'll go back if you're following along with us on screen. An after tax contribution is a type of retirement contribution that shares several similarities with what you'd find with Roth accounts. Reading and I quote, after tax contributions to a 401K are similar to a Roth contribution in that they're made with after tax dollars and don't reduce your taxable income in the year that you make them. So if we're comparing these two, the big similarity is that they are both putting aside dollars after those funds have already been taxed. You are not reducing your taxable income through an after tax contribution or a Roth contribution. But unlike, uh, with Roth contributions, after tax contributions are not subject to the $22,500 limit. This is where the mega in the mega backdoor Roth conversion comes into play, because there is another layer above that initial contribution limit that you may have access to as a participant in your 401, and that is the contribution limit assigned to defined contribution plans. And a 401K is a type of defined contribution plan. If you're following along on screen, you can see that while a 401K has a contribution limit of 22 500, the total limit for defined contribution plans is $66,000, which means that you can, with aftertask contributions, go above the 22 500 and get up to the 66,000. As an example, someone who wants to do a mega backdoor Roth conversion may have a 401K that's pretaxed at their employer, and they max out those contributions, ah, at 22,500 for the year. But if their plan allows after tax contributions, they're eligible to put, in some cases, up to an additional $43,500 in after tax contributions into their plan, which falls within that $66,000 limit associated with defined contribution plan. Let's say that this person, over the years, contributes $200,000 in after tax contributions, and those funds grow to $300,000. Well, like a pretax retirement account, a portion of these funds in aftertask contributions will be taxed as ordinary income. If 200,000 contributions grew to 300,000, that $100,000 of growth would be taxable as ordinary income. But like with Roth accounts, there's a portion of it that wouldn't be subject to taxes. In this case, the 200,000 of contributions would be able to be withdrawn income tax free. But if you're doing a mega backdoor, you don't want to settle for just your contributions being tax free. You want all of these funds to be tax free. So the second step of the megaback door is transferring, uh, or converting those after tax contributions into funds in your Roth 401K. Once that conversion has been completed, you now have an account where these funds are growing tax deferred. And when you withdraw them in retirement, both your contributions and the investment gains associated with that account will be free from income tax. So this is obviously something that requires a number of steps, and it's not something I recommend for someone who's doing it without the help of a CPA or a financial advisor. And after the break, we'll tell you how. Even if you do have most of those professionals in your life, you need to make sure you go about a process of making sure it's a strategy you should be pursuing in the first place.
[00:08:54] Speaker C: This is the new Money New Problems podcast, a show for successful professionals searching for the tools they need to navigate financial opportunities and obstacles they've never seen. We'll be right back.
[00:09:12] Speaker B: Are you wondering what new money problems you might be overlooking in your financial life? If so, we've got great news.
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[00:09:51] Speaker C: You'Re listening to the new Money New Problems podcast. Subscribe
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[00:10:02] Speaker A: All right, before I get into all the negative things that I think about mega backdoor Ross, I will first start with some of the positives. The fact of the matter is, there are people out there who earn enough money and save well enough that when it comes to the 22 500 associated with contribution limits for 401 Ks, 403 B's, it's simply not enough for them to pursue what they're trying to pursue. They may not work for a nonprofit or a health entity where they can do a 457 plan where they can put aside more funds like we talked about for retirement in the previous episode. Uh, maybe they have plenty of savings in their emergency fund. They are contributing to their non qualified accounts, they don't have consumer debt, they don't have student loans, and every single year they truly are trying to find places to put their money. If you're in that situation, and you may be listening to this podcast, and in that situation, then, uh, a mega backdoor has some real benefits. If you think about a Roth, there's a benefit just period in getting taxes out of the way. If you can afford to pay your taxes now so that you don't have to pay them later. But I often hear a common refrain from high income earners that say, yeah, but I make so much money now, my tax rate is so high, why would I pay my taxes now when in retirement I'm going to be paying so much less? Because I'm earning less money. And I would say that even if you're earning less money in retirement, that doesn't necessarily mean you'll be paying less in taxes. One of the things we fail to keep in mind during our earning years are all of the things that we have at our disposal to lower our taxable burden. If you're a homeowner, there's things like the mortgage interest that you're paying on your home, the local property taxes that you pay associated with that home, all of which bring down your taxable income. If you have kids, there's child tax credits like we've talked about in episodes on taxes. There's child independent care tax credits. If you're contributing to a retirement account that's a pretax account, there are significant tax deductions associated with putting funds aside in those vehicles. So all of these things, no matter what you're earning, they are driving down your taxable income. If you're a business owner, you have even more at your disposal to a level that's far lower than what most people realize. But if you're in retirement, much of that stuff goes away. If you've paid off your house, you lose that mortgage interest deduction. Even if you have paid your house down but not off, you're not paying as m much in interest each year. So that deduction is reduced. You're now in retirement, so you're not contributing to a retirement account and getting that tax deduction. You're now withdrawing from those funds and paying tax on the withdrawals. If you have children, those children are likely out of the house, or even if they're not out of the house, they're in a position where you can't claim them as a dependent. So all of those tools that you are using to lower that taxable income have gone away, and you're a much bigger target to the IRS on a year to year basis. So for that reason, using a mega backdoor Roth conversion can position you to have some really tax advantaged funds. But here's the problem. There are far fewer people out there who are trying to find things to do with their money than there are people who are trying to take one arrow and shoot it at multiple targets. And in those cases, I want people to have some balance in how they build their investments. It's not beneficial to have 80 and 90% of your net worth in an account that you can't access, in many cases till 59 and a half, as compared to having three different levels of savings, your emergency funds, your non qualified funds, your qualified funds, and also having the ability to pay extra towards consumer debt to pay your income driven repayment plans for your federal student loans. So when I have people who come to me and they talk about this strategy, I first ask them, do you have three to six months of expenses set aside in your emergency fund? Do you have substantial funds in a non qualified investment account that you can access before 59 and a half? Are you already maxing out the 22 500 in your pretax or your Roth 401? Do you have consumer debt that you're paying at a high rate of interest, like a credit card? Do you have the appropriate amount of life insurance to cover the risk that you might die, or the appropriate amount of disability insurance to cover the risk that you may not be able to work? Do you have family that depends on your income, either irregularly for large amounts or consistently for smaller amounts? Do you have a plan in place if something were to happen to your parents or your in laws to cover the cost of their health care in the event of an emergency or an extended level of care, which could last an unknown period of time? That's a lot of variables to consider. But if you can't answer all of them in the positive, then you need to be careful about how much of your net worth or how much of your yearly savings you're dedicating to accounts that have access restrictions associated with them. So while that may seem OD to do this whole episode and then tell you at the end that nine out of ten people shouldn't do it, you might be that one out of ten, but if you're the nine out of ten, uh, I wanted you to understand what people are talking about when you hear them mention mega backdoor roths, but also understand where you fit in relation to the strategy that's right for you versus the strategy that you hear about at cocktail and dinner parties.
[00:15:00] Speaker B: See you next week from new money new problems. This was the new Money New Problems podcast, a show for successful professionals searching for the tools they need to navigate financial opportunities and obstacles they've never seen.
