TRANSCRIPT:
Hi, I’m Jeremy Riggs, Certified Financial Planner with Base Wealth Management. Today, I’m going to walk you through an ingenious way to create tax-free growth in your 401k. This strategy is known as a mega backdoor broth. A mega backdoor broth is the ability to contribute after-tax funds into a 401k plan above the general employee limit. For 2024, if you’re under 50, that limit is $23,000. If you’re over 50, an additional catch-up of $7,500 is permitted. Once you’ve maxed out the employee limit, depending on your plan, you can put after-tax money into the 401k. You do not receive a tax deduction on the contributions, and the funds grow tax-deferred. The backdoor aspect is to immediately convert the after-tax money to broth dollars, and here’s why you’d want to convert them sooner rather than later. I recently implemented this strategy with a client, Sarah, who is motivated to retire early and here’s what we mapped out.
We plan to contribute $5,000 each year for the next 20 years. We use an average return of 8%, and she plans to retire at 60. At that point, she’ll have $247,000. Of that, $100,000 of what she contributed. When you leave the employer plan, the $100,000 rolls into a Roth IRA, and it’s yours tax-free because you paid the taxes on it already. The remaining $147,000 would roll into a traditional IRA, and it will be taxed as income when you withdraw it. Now, let’s take this example, and say you did not stop at just contributing the after-tax dollars into your plan. You immediately convert the after-tax money to Roth, and since you already paid the tax on it, there’s no additional tax consequences to you. We’ll use the same 20-year timeframe and the same 8% growth rate. At retirement, you can roll the entire $247,000 balance into a Roth IRA, and it’s all yours.
In addition, you also avoid the required minimum distributions on Roth IRAs, making them a wonderful legacy vehicle. Now you may ask, but wait, aren’t there income limits on being able to contribute to a Roth? That’s the beautiful thing about a 401k. There are no income restrictions on how you contribute. In addition, the reason it’s called a mega backdoor Roth is the contribution limits on a 401k are much higher than an IRA. You may have the ability to accomplish a similar funding strategy using a traditional IRA and Roth IRA. There are some pitfalls when deploying a backdoor strategy using IRAs, but I strongly encourage clients to work through with a certified financial planner. So where does a mega backdoor Roth fit into a savings plan? Most clients, if they’re considering this strategy, are close to maxing out what they can do on a pre-tax or Roth basis in their employer plan. This savings hierarchy I tend to use is to contribute enough to receive your employer match.
If available, max our your HSA, because of the triple tax advantages, make it one of the best savings vehicles we have in the United States. If you still want to save more for retirement, then come back to your 401k to utilize a mega backdoor Roth. I hope you found this walkthrough helpful. For more ways to supercharge your savings, book an appointment today and subscribe to our channel for more insights. Thanks for watching. See you next time.
