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Here’s a retirement tax trick: the mega backdoor Roth IRA

The Internal Revenue Service building in Washington, D.C.
Retirement planning should consider ways to minimize taxes after you stop working. A Roth IRA, which is funded with after-tax dollars, is one tool. For those who have already contributed the maximum, the mega backdoor Roth IRA might be an option.
(Andrew Harnik / Associated Press)

Dear Liz: I am a 32-year-old married father of two. My income is high enough to contribute to my kids’ 529 and custodial brokerage accounts. I’ve been able to max out my 401(k), health savings account and backdoor Roths for my spouse and myself. Next, I’m debating between starting a life insurance retirement plan (LIRP) or making after-tax 401(k) contributions because my plan allows mega backdoor Roth conversions. What are your thoughts on LIRP versus mega backdoor Roth?

Answer: Mega backdoor Roths are such a sweet deal for higher-income workers that you probably should take advantage if you want to put aside more tax-advantaged money for retirement.

For those who are unfamiliar: Roth IRAs allow tax-free withdrawals in retirement, but only people with incomes under certain limits can contribute directly to a Roth. The ability to contribute phases out for married couples filing jointly with modified adjusted gross incomes of $204,000 to $214,000.

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There’s no income limit on conversions, however, so people with higher incomes can contribute to a traditional IRA and then convert the contribution to a Roth IRA in what’s known as a backdoor Roth. Conversions typically trigger income taxes on any pretax contributions or earnings, so this tactic works best if the person doesn’t have a large existing IRA.

The mega backdoor Roth takes this strategy to a new level.

Some employer 401(k) plans allow participants to make after-tax contributions that can then be converted to a Roth. The amounts that can be contributed and converted are substantial. Although the pretax limit for contributions is $20,500 for workers under 50 in 2022, the total amount that can be contributed by employees and employers to a 401(k) is $61,000.

The amount you can put in after tax would be reduced by any company match you get. Assuming there’s no match, you could contribute $20,500 to the pretax plan and an additional $40,500 to the after-tax plan this year.

A mega backdoor Roth would allow you to build up a substantial fund of tax-free retirement money without the costs and other potential disadvantages of a LIRP, which requires you to buy a permanent life insurance policy. With a LIRP, you would use the cash value of the policy to hold investments that you could access tax free through withdrawals or loans.

LIRPs can make sense if you otherwise need permanent life insurance, but many people need only term insurance, which is much less expensive.

If you’re still interested in a LIRP, consult with a fee-only, fiduciary financial advisor first to ensure you understand how these work and determine if they’re a good solution for you.

Some bosses consider telework as a benefit. Many workers don’t see it that way but are willing to accept a lower salary, up to a point.

Social Security divorced spouse benefits

Dear Liz: You recently answered a woman about collecting on her ex-husband’s Social Security record. You said she was eligible for a spousal benefit if they were married at least 10 years, which they were. I think you should have added that the spouse needs to be collecting their own Social Security when you apply. A Social Security rep told me I had to wait till my ex retired and then I’d automatically get the larger benefit. I waited. Eventually I asked my ex and he said he had started collecting Social Security some months previously. I applied and did get a retroactive payment.

Answer: Unfortunately, people don’t always get correct information from Social Security representatives.

You did not have to wait for your ex to begin receiving Social Security to apply for a divorced spousal benefit. While that’s a requirement for still-married couples — the primary worker must apply for their own benefit to trigger a spousal benefit — a divorced spouse has only to wait until their ex turns 62 and is eligible to receive Social Security retirement checks.

The representative you talked to may not have understood that you were talking about an ex rather than a current husband, or the rep may have been confused about the rules.

Because Social Security can be so complicated, it makes sense to educate yourself as much as possible about the rules. Books like Jonathan Peterson’s “Social Security for Dummies” can be helpful; just make sure to get the latest edition, since the rules for spousal benefits changed substantially in 2015.

Liz Weston, Certified Financial Planner, is a personal finance columnist for NerdWallet. Questions may be sent to her at 3940 Laurel Canyon, No. 238, Studio City, CA 91604, or by using the “Contact” form at asklizweston.com.


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