Pushing the Limits of Your Roth IRA

Christine Benz:

Hi, I'm Christine Benz from Morningstar. How can you supersize your Roth IRA balance? Joining me to discuss the mega backdoor Roth IRA is author and tax-planning expert Ed Slott.

Ed, thank you so much for being here.

Ed Slott:

Great to be back with you, Christine. Thanks.

Benz:

It's great to have you here. Let's talk about this mega backdoor Roth IRA. Businessman Peter Thiel made headlines recently for getting $5 billion into a Roth IRA. Most people don't have the strategies at hand that he was able to use, but there is a strategy that people can enlarge their Roth IRAs with, and it involves using aftertax 401(k) contributions. Can you talk about that? Because that does seem like that's the starting point for being able to get more funds into a Roth IRA than you would be able to get if you're just contributing the $6,000 per year that you're able to do?

Slott:

Well, first with Peter Thiel: He didn't do anything illegal. Remember, people think he had billions of dollars. You know, it's like the old joke: How do you become a billionaire? First, you have to have $1 billion and then... He didn't have $1 billion. Back in 1999, he contributed the legal amount of $2,000--that's what it was back then--to his Roth IRA. He was under the income limits, so he was allowed to do it. Then he invested $1,700 of that $2,000. The $2,000 is the only money he ever put in a Roth IRA. And of course, it took off like a lottery ticket type of investment--it should only happen to everybody! So there's nothing wrong with what he did.

It got people thinking, as you say, How can I do that? Well, you know, unless you have that information and that intuitive--whatever it is. I don't want to say inside information. But unless you're a super-investor and lucky, maybe, too, that's probably not going to happen to you. But you can make it happen using the tax law through your employer's 401(k). So that's the starting point for this thing we call the

mega backdoor Roth IRA.

Because there's a separate backdoor Roth IRA. This is the mega backdoor. This involves being in a company plan, which means you have to be employed by a company. So there's a few obstacles here. It's not all it's cracked up to be. It sounds good because, in some cases, you can put up to $58,000 in an aftertax account in a company plan, and then take it out and roll it to your Roth IRA tax-free, $58,000 a year.

So there's a few hurdles. The biggest hurdle is the company has to qualify. There are discrimination and testing rules to prevent higher-income employees from gobbling up all the benefits and leaving lower-paid employees without the benefit. So there's discrimination rules that some big companies can handle because they have a bigger pool of employees to get that average over more people. But a smaller company, like, let's say you have a group of doctors or lawyers, maybe 10 people or so or a little more, but you have this wide gap between higher-paid people and lower-paid people. They probably wouldn't qualify under the discrimination testing. So that's one thing. You know who does qualify? People with no employees. You have a solo 401(k)--you don't have to worry about any of that. So if you have your own business, and you have a solo 401(k) without any employees besides you or a spouse, you don't have to worry about that hurdle.

But assuming you get past that hurdle, the employer--the company--has to offer aftertax contributions. Now they don't have to do it. It's optional. So that's the first test: Do they offer it? Many more companies are offering that. Then they have to allow in-service distributions, even before 59.5. Not everybody offers that. Again, it's optional. And the third probably the biggest hurdle, you have to have the disposable income to put that kind of money away. It sounds great, "Oh, $58,000." Well, that's going to come from your own pocket. So you have to have that money available.

If all these planets are aligned and you can do that, yes, you could put up to, say, $58,000--that's the amount for 2021 in an aftertax account--in your 401(k) assuming they allow it and all those factors I went through. And then if they have the in-service distributions, you could take that money out before it earns too much, roll it over to your own Roth IRA. And there you have all that money going into a Roth IRA, say $58,000 a year, way more, like you said, than the $6,000 limit or even $7,000 limit if you're 50 or over. And unlike the Roth contributions--the $6,000 or $7,000, which you may not qualify for if your income is too high--there is no income limit. You could be making $1 million a year at the 401(k) and still qualify to put, say, up to $58,000 away in the Roth. And if you do qualify, say your income's under and you do qualify for Roth contributions, the $6,000 or $7,000, you could do both.

Benz:

You referenced the aftertax contributions. And I think some people hear that and they think, "Well, that's the same as Roth contributions, which are also aftertax." Can you explain the difference in this situation? And also whether or why one might fund the aftertax contributions in lieu of the Roth 401(k) contributions? It seems like the Roth 401(k) contributions--at least making those that should be the starting point, right?

Slott:

Well, as I said you could do both if you qualify for Roth contributions. But let's say you do, you don't, that doesn't really make a difference, it's just an add-on. Look at the 401(k) plan, the average 401(k). And they don't all offer all of these options. But look at it like it has four separate baskets. You have the traditional 401(k) funds. That's what most people are used to. That's pretax--that money hasn't been taxed. You get a deduction going in. Then you have the Roth 401(k) if they offer and lots more companies do offer it now: That's aftertax. But then they have these other two baskets, if they have it--the aftertax, which is not the Roth 401(k). It's a separate aftertax account where you could load up and then do this mega backdoor Roth to your Roth IRA. And then there's a fourth basket most companies have for matching contributions--that are always pretax.

So, yes, you could load up the Roth 401(k). But you could only go up to the deferral limit, the $19,500 for 2021, plus another $6,500 if you're 50 or over. If you want to go up to the $58,000, you'd have to do it in that aftertax account if you want to "mega" it, so to speak. So there's lots of options. But the bottom line is to mega it--by "mega," we mean increasing it to the max. Getting the $58,000 would have to involve maxing out on that aftertax account, not the Roth 401(k). It is confusing because they're both aftertax accounts. But the Roth 401(k) is limited to the deferral--the amount that comes out of your salary, which is $19,500 for '21 plus $6,500, if you're 50 or over--but that still leaves you somewhere around $38,000 you could put in the aftertax, again, back to what I said earlier, if you have the disposable income to put in there.

Benz:

Right, that seems absolutely key. You referenced this in-plan distribution feature. What if a plan doesn't offer that? What are the options then? And what are the tax consequences in that situation?

Slott:

Well, if they don't offer it, hopefully you could load up the Roth 401(k) for at least the deferral amount and maybe park that money in the aftertax account until you're eligible for a distribution. But most companies, it seems now--I know there was some studies done recently by Fidelity, they said about 90% of their plans offer it. If they have the aftertax, one of the great features of the aftertax account, not the Roth 401(k), is you could have in-service distributions. And you don't have to wait till 59.5, which you might have to wait, say, in the other accounts in that plan. So, you could be 40 and start doing this every year, taking advantage of the aftertax account and then rolling it to your own Roth IRA each year. And putting in essentially, if you have the money, up to $58,000 in your Roth, and if you qualify for the contribution, maybe another $6,000.

Benz:

You referenced a few times, Ed, that this is for high-income, heavy-savers. You need to have a lot of income to be able to take advantage of this feature. Seems like for people in that situation, they really have a fork in the road where they could do these aftertax 401(k) contributions or the other option for the overage would be to simply save in a taxable brokerage account or something like that. Can you talk us through which is the better option?

Slott:

Well, the better option's always going to be the aftertax because that can go into a Roth and grow tax-free. Taxable accounts, even if you get favorable capital gains rates, still are going to be taxed, maybe at a lower rate. And we don't even know what the future on that is with pending legislation. But it will be tax. Plus, you have administrative tax reporting--every time you buy and sell that's reported in a taxable account. You can buy and sell all day in a retirement account--in the aftertax or in your Roth IRA--and that doesn't have to be reported anywhere. And when the money comes out, eventually, if you qualify, have it for five years, and you're 59.5, it's all tax-free. So you can't beat a 0% rate.

Benz:

How about prior to age 59.5? Can you walk us through? Someone's paid taxes on these funds. Do they have access to them in any fashion prior to retirement age?

Slott:

Well, generally, you have to have the five years or 59.5. Let's go back to the Peter Thiel story because it's not over yet. Everybody's talking about his $5 billion in his Roth IRA. But remember, Roth IRAs are included in the estate. Now, from what I understand, I may be off, I think he's 53, 54 years old--he can't touch any of that money in his Roth until he's 59.5, except his $2,000. His $2,000 he could get out because that's his contribution. You could always take that out tax- and penalty-free at any time, for any reason. So he has access to the $2,000. The $5 billion, he'll have to wait. So, maybe we'll set up like a GoFundMe page to get him, you know, as a bridge loan, to get him to 59.5 or something. But he can't touch the rest of that money. It's all earnings without tax and a penalty 'til 59.5. By then, it might be worth $10 billion. And if he lives a long and healthy life, and he lives well into his 80s, let's say, it could be worth $50 billion, but at some point, the government's going to get a good cut of that through estate tax.

Benz:

Ed, great information as always. Thank you so much for taking the time to be here.

Slott:

Thanks, Christine.

Benz:

Thanks for watching. I'm Christine Benz from Morningstar.