Tax Free Mega Backdoor Roth IRA
This post highlights one of our personal next steps to Financial Independence: Fully funding a tax free mega backdoor Roth IRA (no federal income taxes). And yes, this is LEGAL! I have built this plan using the Mad Fientist’s Roth conversion ladder as one of the cornerstones. If you are not familiar with that check it out here.
Let’s start with strategy. Our take on this is going to focus on the fact that we have a pretty low cost of living. My wife and I got indoctrinated into the Dave Ramsey plan early in adulthood. We got out of all consumer debt and cut a lot of waste out of our spending (We still buy things we want but we do not buy excessively). This lifestyle allows for significant savings rates and opens the door to options.
Fundamentally, if you can max out your available pretax buckets, there is potential to drop your tax bracket low enough that the standard deduction and child tax credits (CTC) eliminate any federal income taxes. While that’s cool and all, we can take it a step further. If you get your tax bill down to $0, then there is a possibility of doing a mega backdoor Roth IRA without paying taxes. What!? If you do this for more than 5 years, you can make withdrawals when you hit early retirement while simultaneously laddering your 401k to the Roth IRA. This could get 100% of your nest egg to a position where it never gets taxed or penalized. Never!
Note: There are other tax credits that could help achieve this too but the CTC is my focus for now.
You still tracking with me?
Alright, lets break it down.
Part 1: The Fundamentals:
- What is an HSA?
- What is a Roth IRA compared to a traditional IRA?
- How does a Mega Backdoor Roth IRA work?
Health Savings Account (HSA)
A Health Savings Account is a tax-sheltered account that can be used to save up for and pay medical expenses. I intend to dig more into its triple tax benefits in future posts. For now, the main point is that any contributions that go into the HSA are pretax and therefore reduce you tax exposure. See here for my post on how I account for the value of HSA’s when comparing health insurance costs.
Traditional IRA vs Roth IRA
A traditional IRA (Individual Retirement Arrangement often mistaken for Individual Retirement Account) is a tax break that allows you to invest with pre-tax dollars for retirement but then all withdrawals are subject to taxes. It is also penalized if pulled out before you are 59.5 yrs old.
A Roth IRA on the other hand, is a retirement account that is actually funded with post-tax dollars but then grows tax free. There are a few other advantages that include:
- Direct contributions to a Roth IRA can be withdrawn tax and penalty-free at any time
- Rollover contributions in a Roth IRA can be withdrawn tax and penalty-free after 5 years
- Distributions from a Roth IRA do not increase your Adjusted Gross Income
- The Roth IRA does not require distributions based on age
The 2020 contribution limits for traditional or Roth are $6,000/yr.
Mega Backdoor Roth IRA
Note: To make this work you need to have a 401k at your job that allows:
- After tax contributions
- In-service distributions
In essence, the mega backdoor Roth IRA is a loophole in the tax code that allows you to contribute far beyond the standard Roth limit into a Roth IRA. It is accomplished by the fact the IRS allows up to $57,000 in total contribution to your employer’s retirement plan based on 2020 laws. See for yourself.
“Total” means both you and your employer. Pretend that your company does not contribute anything to your 401k, then this means you are allowed to contribute up to $57,000. The catch is that you can only put $19,500 into your 401k. This seems like a contradictory statement, but some employers are setup in a way that you can actually save above that amount in an after-tax contributions. This is key.
The second critical step is having the ability to take in-service distributions so that you can role that money into a Roth IRA while still employed at the same employer. If this is not allowed, you will not be able role your Mega Backdoor Roth over until you leave your job.
If you are lucky enough to have both of these options available, Congratulations! Mega Backdoor Roth can be achieved. Here are some examples of what it would look like:
Example 1:
You contribute the max to your 401k ($19,500) and your employer matches nothing. If they are setup with the criteria above, then you can contribute $37,500 to a Mega Backdoor Roth.
Example 2:
You contribute the max to your 401k ($19,500) and your employer matches 50%. This means that you have a total of $29,250 going to your 401k. If they are setup with the criteria above, then you can contribute $27,750 to a Mega Backdoor Roth.
Part 2: Understand Your Tax Burden and set up a Mega Backdoor Roth:
As stated in the intro, if you can contribute enough in pretax options to lower your effective tax rate down, then you have the ability to do the post-tax contributions at a significant discount.
What if you can get your effective tax rate to 0%??? This would be an unbelievably powerful tool and can be fueled by 401k’s, HSA’s, and other tax shelters.
And then there are tax credits and deductions…
With recent tax laws, there have been a significant increase in standard deductions and tax credits. Families that are filing joint with children under the age of 17 have potential to knock their effective tax rate to 0% even at relatively high incomes!
As of 2020 here are a few key points:
Take the case where a couple is Married Filing Joint. Right off the bat, they have a $24,400 standard deduction. We will also have them maxing out a 401k and HSA which is $19,500 for 401k and $7,100 for HSA for a grand total of $26,500 pretax.
So far, we are sitting at $51,000 that can be earned without any federal taxes. This is even before accounting for child tax credits. Once you start adding them into the mix, it is important to realize that these are credits, not deductions, which means $1 dollar of credit negates $1 in taxes. This is much more powerful than a deduction. For every dependent under 17 years old, this couple can make the equivalent income that results in $2000 of taxes and still come out neutral. Running out the numbers for a range of family sizes we ended up with the following chart:
This chart has three main sections:
- Below the orange line – Incomes that are below the orange line can actually achieve a $0 tax bill by simply using the standard deduction and utilizing the allowed child tax credit. They do not have to use any other pretax buckets to drop their income down.
- In between the orange and blue lines – These are the cases where $0 taxes can be achieved but require the use of pretax savings in the 401k’s and HSA’s on top of the standard deduction and child tax credit.
- Above the blue line – Cannot achieve $0 in taxes, but do not let this discourage you! You are still paying a significantly reduced tax bill compared to someone not maxing out their pre-tax options. This is a great place to be.
Notice that if you have 3 kids, and are married filing joint, you can make over $ 100,000 without paying a dime to federal income tax. That is amazing!
Part 3: Level Up
Let’s take a family of 5 (3 children) making $100k/yr as our case study for a Mega Backdoor Roth. They can eliminate federal income tax, max out a mega backdoor Roth IRA / 401k / HSA giving them a savings rate of 64%. This also leaves them ~$36k/yr to live on. If this does not sound like much to you, remember, they have no consumer debt (car payments, overdue bills, etc). Depending on how far along they are, maybe they don’t have a house payment either (there are a lot of mixed feelings about paying off a house early so we came back and added a link to a later post).
$3k/month is actually a lot if your finances are in order.
Note: If you are in debt, and feel trapped by it, this may sound overwhelming and unrealistic. I will eventually do a post that takes you down our path. Essentially, we started with the Dave Ramsey Baby Steps and are now in pursuit of financial independence. There is cool transition point between the two, and I see FI as the graduate level class that comes almost naturally from the Dave Ramsey undergrad.
Not only do they get by without taxes, but the portion that is contributed to the Mega Roth is considered a rollover. If you remember what we said above, in “Traditional IRA vs Roth IRA“, Bullet points 2 & 3 were:
- Rollover contributions held in a Roth IRA can be withdrawn tax and penalty-free after 5 years
- Distributions from a Roth IRA do not increase your Adjusted Gross Income
They are creating a retirement nest egg that can be accessed before traditional retirement age, as long as they wait 5 years. This means that if they stay on this course, after 5 years, the first portion that was contributed will be accessible. The next year, another portion will become available, and so on.
If they assume an 8% rate of return, Financial Independence hits in ~10-11 years (because I am not counting the HSA in the FI number). We arrived at this by using the 4% rule of thumb. If you can live off of 4% of your nest egg, then there is a high probability that it will sustain itself in perpetuity. We will round up their living expenses in the scenario to ~$40k/yr. Therefore, their nest egg has to be ~$1M to be at financial independence:
Once they are retired, they can start the Roth conversion ladder for their 401k because they will have no income. They will be living off of Roth dollars which do not increase their Adjusted Gross Income. This means that they could roll the 401k over at a rate slow enough that it never sees taxes either. Finally, because everything is being converted to a Roth IRA, they will never be forced to make minimum distributions.
Summary:
Maybe you don’t have children or are not married… you may not be able to get your tax rate down to 0%. However; how are you looking at your specific set of circumstances to optimize your retirement goals? Have you thought about how to minimize your taxes? Can you improve how you are going to be accessing your money inoder to reduce taxes/penalties? Hopefully, this post helps build on the mentality of the FI community: Understand the Rules of the game so that you can play it better.
FI- Financial Independence
If your company allows after tax contributions and in-service distributions. PLEASE leave a note in the comments below! It would be fantastic to compile a list of companies that provide this amazing benefit.
Until Next time, Continue to Choose Beta
– Chris
Cover Photo by Riccardo Annandale on Unsplash
