If you’re looking for a new way to invest and save money on taxes, consider strategies such as the backdoor Roth. This is a highly effective way for people to save for retirement while cutting back on future taxes. 

With that said, it’s important to know how to use backdoor Roth strategies to fully leverage the benefits. Here, you’ll find a complete guide. 

Backdoor Roth IRA

Before you can understand the mega backdoor Roth, you’ll need to learn a bit about Roth IRAs. When you have Roth IRAs, you can contribute money you’ve already paid tax on, allowing that money to accumulate and distribute – 100% tax-free.

However, there are restrictions: Namely, income limitations prevent high-income earners from contributing to Roth IRAs, and overall contributions are limited to $7,000 as of 2024 (or $8,000 for people who are at least 50 years old).

Despite this, there is a way for people who can’t contribute to a Roth IRA due to income restrictions, to enjoy the associated benefits.

The “backdoor Roth” strategy allows investors to first make an after-tax contribution to a traditional IRA and then convert that traditional IRA into a Roth IRA. Since the funds first went to a Traditional IRA on an after-tax basis and then were converted to a Roth IRA, the normal income limitations do not apply (hence the “backdoor” nickname). Furthermore, since the contributions were made after tax, you don’t have to pay taxes again at conversion.

IMPORTANT – due to the IRS’s pro-rata rule – having existing pre-tax money in IRAs while using this strategy could lead to a huge tax bill. If you have pre-tax traditional IRA dollars on your balance sheet, you will need to pay taxes on a pro-rata amount of the pre-tax to after-tax balances. As a result, we generally do not recommend clients use the backdoor Roth strategy unless they have zero pre-tax traditional IRA dollars on their balance sheet.

Please consult with your financial advisor and/or CPA to determine how this may affect your situation. 

Mega Backdoor Roth 

As its name implies, the mega backdoor Roth is effectively a supercharged version of the “normal” backdoor Roth strategy. This strategy is made available to certain employer-provided 401(k) plans — not all plans will make this available.

If you have a 401(k) plan, the total amount that can be contributed in 2024 is $69,000. This includes the maximum $23,000 pre-tax and/or Roth payroll deferral — plus employer matching, profit sharing, and after-tax contributions. 

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How It Works as a Tax-Shelter Strategy

Ideally, mega backdoor Roth conversions will create a tax shelter for a portion of your wealth. To take full advantage of this strategy, you’ll need three crucial ingredients:

• After-tax Contributions. After-tax contributions are the secret sauce that makes mega backdoor Roth possible. These fall into a separate “bucket” than pre-tax or Roth 401(k) contributions. If this is available to you, you will see three separate contribution options - pre-tax, Roth, and after-tax. 

• In-Plan Conversion. After making your after-tax contributions, your 401(k) plan will need to allow for in-plan conversions of the after-tax contributions to the Roth 401(k). Some plans will allow you to elect for your after-tax contributions to automatically convert to Roth. Other plans require participants to call in to complete the conversion - a worthwhile hassle. IMPORTANT - if your plan does not allow for conversion of after-tax contributions to Roth, then the mega backdoor Roth is not applicable to you. After-tax contributions will still grow tax-deferred, but their growth is taxable as earned income at distribution. Only by converting to the Roth 401(k) is the growth distributed tax-free. 

• Money to spare. Mega backdoor Roth conversions are an excellent way for people to invest extra cash. However, your first priority should be maxing out a Roth IRA and a 401(k). If you still have a good amount of money left after accomplishing that, it might be time to start seriously looking at this strategy.

If a Mega Backdoor Roth Strategy Doesn’t Work for You…

The mega backdoor Roth strategy can be a great way to save money and avoid taxes, but it’s highly situational. If this strategy doesn’t fit with where you are right now, focus on finding other ways to enjoy the Roth treatment – after all, this conversion strategy isn’t the only way to invest money tax-free. Some other Roth-related investment options include:

• Directly contributing to a Roth IRA, if your income is below the limit

• Using the backdoor Roth strategy, if your income is above the limit

• Contributing to a Roth 401(k), if your employer offers this opportunity

In The Crosshairs

All backdoor Roth investment strategies can be beneficial, but they’re not immune to controversy.

Today, many big tech companies now offer conversion-friendly 401(k) plans. But the increasing popularity of this strategy has attracted heat from critics who view it as an unethical perk favoring high-ranking corporate executives. And there are consistent legislative proposals that would seriously change how Roth conversions can be used.

We don’t know how long this benefit will remain available to investors. 

Most recently, the Build Back Better Act, if passed, could have prohibited rolling over after-tax 401(k) contributions to Roth IRAs and Roth 401(k)s among all taxpayers, no matter what their income level is. 

Know Your Best Options

Backdoor Roth strategies may be right for you, but you’ll need to play your cards right to reap the rewards. If you aren’t careful, you could get slammed with sizable penalties.

Instead of attempting this intricate strategy without support, most taxpayers should seek the help of a qualified financial advisor first. 

The team at Consilio Wealth Advisors specializes in helping tech employees build wealth, and we’re highly familiar with all sorts of investment strategies (including mega backdoor Roth conversions). Don’t put up with a financial advisor who acts like you should already know everything — get help from the friendly faces at Consilio and know that your financial future is in the best hands. 

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Disclosures: 

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

Consilio Wealth Advisors, LLC (“CWA”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where CWA and its representatives are properly licensed or exempt from licensure.