Menu Close

IRA Financial Group Blog

The Greatest Roth Tax Strategy You Never Heard Of – Episode 247

roth tax strategy

IRA Financial’s Adam Bergman discusses the Mega Backdoor Roth 401(k) and how it supersizes your tax-free (Roth) retirement income. By making after-tax contributions to a 401(k), you can move those funds into an IRA and convert them to a Roth.

The best Roth tax strategy involves the after-tax 401(k) plan. While there are no tax benefits of utilizing this option right away, you can grow these funds tax-free. There’s no upfront tax deduction like a traditional plan, and this isn’t a Roth 401(k). So, why do it? Well, that’s what this episode will focus on. Mr. Bergman will show you how you can supercharge you tax-free money for use at retirement.

What is a Roth?

Most people know what a traditional retirement plan, such as a 401(k) or IRA, does. It allows you to save pre-tax money in a tax-advantaged account, which grows tax deferred until you withdraw the funds. The best part is that you don’t pay taxes on any amount contributed to the plan. On the other hand, a Roth plan does not have the immediate tax break, since they are funded with after tax funds. Taxes are paid before you contribute them to a Roth plan. However, all qualified distributions are tax free.

What is a Qualified Distribution?

In order to receive the full benefit of the Roth plan, any distribution (or withdrawal) must be qualified. Basically, there are two things that need to be in place for a distribution to be qualified. First, you must be at least age 59 1/2. As with other plans, withdrawals prior to 59 1/2 are hit with a 10% early withdrawal penalty. Secondly, the Roth account must be opened for at least five years.

If both conditions are met, all funds withdrawn from your Roth are tax free! However, the distribution is unqualified, you will get taxed on all earning in the plan. For example, if you contribute $1,000 to a Roth and it grows to $2,000, it has $1,000 in earnings. If you make an unqualified distribution of the entire amount, you will be taxed on that $1,000 in earnings. Note: you may withdraw contributions at anytime without penalty, since you’ve already paid taxes on those funds. Since earnings were not taxed, they must be withdrawn at the correct time, or you lose out on the benefits of the plan.

What is the Roth Tax Strategy?

The Roth tax strategy is also known as the “Mega Backdoor Roth 401(k).” This will allow you to contribute after-tax funds to your 401(k) plan and then roll them into a Roth IRA. Generally, when you want to move funds from your 401(k) to another plan, there must be a qualifying event. These include reaching the age of 59 1/2, separating from your job and the termination of the plan. However, this does not apply to after-tax (non-Roth) contributions. You can transfer those funds whenever you want. This is the crux of the strategy.

First and foremost, your plan must allow for these types of contributions. You need to ask your plan administrator to see if they are allowed. If allowed, you may contribute up to $19,500 or, $26,500 if at least age 50, for 2020 in after-tax funds. You may then immediately roll all those funds into a Roth IRA.

Why not Just Contribute to a Roth IRA?

You may be thinking, why can’t I just contribute to a Roth IRA instead of my 401(k)? The simple answer is the contribution limits. You can only directly contribute up to $6,000 ($7,000 if age 50+) to an IRA in 2020. This Roth tax strategy is the only way to contribute more without a qualifying event.

What Makes it “Mega?”

While the 401(k) limits are much higher than that of an IRA, they aren’t exactly “mega.” However, if you are self-employed, those limits skyrocket to $57,000 or $63,500 if at least age 50 by funding a Solo 401(k) plan. Further, as a self-employed individual, you get to choose your plan provider and all the facets of the plan. If you want to utilize this strategy, you just need to make sure the plan will allow for after-tax contributions.

A Solo 401(k) allows for the same contribution limits as mentioned above, as the employee. However, it also allows you to make contributions as the employer. The amount you can contribute is based on a percentage of your self-employed earnings. This amount is either 20 or 25%, depending on what types of business you are (sole proprietor, partnership, corporation, etc.).

One last benefit of the plan is that Roth IRAs do not have required minimum distributions. Traditional IRAs and 401(k) plans (along with Roth 401(k) plans) mandate that you must start taking distributions once you reach the age of 72. However, Roth IRA funds can continue to grow unhindered for as long as you wish.

Conclusion

The whole point of the Mega Backdoor Roth tax strategy is the ability to supercharge your tax-free income during retirement. If you are self-employed, it’s recommended you consider your options when retirement planning. It’s also important to work with a credible financial advisor or planner to make sure this path is right for you.

Mr. Bergman goes into detail of the strategy and other factors to consider in this podcast. As always, we thank you for listening and hope you’ll check out our other podcasts on our SoundCloud page. See you all next time!

Related Articles