Here’s an interesting retirement funding idea that may appeal to some of you. It’s rattled around certain blogs and forums the past few months; as best I can tell it starts here on White Coat Investor, an investing website aimed at doctors. I first saw it on FatWallet Financial, though there’s also some discussion on Bogleheads and on Mr. Money Moustache.
Enough buildup–what is the Mega Backdoor Roth IRA? It’s a clever circumvention of standard Roth IRA funding limits. I’ll quote the original article from White Coat Investor:
Some 401Ks not only permit $17.5K of either tax-deferred or Roth contributions, but ALSO permit you to contribute your own, after-tax money into the plan up to the $52K limit. A good example of this is the TSP for deployed military doctors. It isn’t a particularly good deal to just contribute after-tax money, UNLESS you can then get that money out and convert it to a Roth. Voila- A Mega Backdoor Roth IRA. Instead of only being able to contribute $5.5K per year, all of a sudden you can contribute $34.5K (plus the $5.5K in your personal and $5.5K in your spousal IRA.) If you’re over 50 and put your first $23K (remember the $5.5K catch-up contribution) into a Roth 401K, you could potentially put up to $65K per year into a Roth IRA.
Not everybody can do this. You need to have a certain type of 401k plan:
- The plan must allow for after-tax contributions above and beyond the $17,500 employee contribution limit, preferably up to the $52,000 limit. So you can put in your $17,500 that is either tax-deferred or Roth, then contribute another $34,500 to the plan in after-tax dollars, similar to a non-deductible traditional IRA.
- The plan must allow for non-hardship in-service withdrawals of after-tax contributions.
- The plan should prohibit non-hardship in-service withdrawals of tax-deferred contributions (not mandatory, but a useful feature.)
- The plan should allow for “lump sum” contributions (not mandatory, but useful.)
I’m not sufficiently knowledgeable to comment on whether or not this is a good idea, hopefully Matt or George will weigh in. I just wanted to air it out here since I hadn’t heard of it before. What do you all think about this one?
I try hard not to get my clients involved in the tax court system and prefer to stay away from “schemes” that now that they are well publicized their time is probably numbered. Very limited appeal. But could work well in some cases I guess. Probably no readers should attempt this from now on. Will likely be on the target list after they chop up this “inversion” shenanigans…
What’s “inversion”? Hadn’t heard about that one.
The guidance on this is very very murky. If you could somehow contribute a large after-tax amount and then immediately roll it out of your employer sponsored plan and into a Roth IRA, it MAY work. But if you have pretax contributions and/or earnings built up on your after-tax contributions…I’d steer clear. I’m sure the IRS will issue better guidance on this in the year 2080
Google Walgreens and tax inversions. They got shamed into not going ahead with it…for now.
I think you’d probably get away with it. Just because the IRS is so messed up, most likely I wouldn’t advise people to do this. As George says you are opening up convoluted things that might bring unwanted attention on you.
I like things like this from a theoretical perspective, and certainly enjoy writing about them, but I wouldn’t find many situations where it would be the best course of action. I can see the appeal for a Doctor or other highly paid consultant (sole practitioner) since they would have higher incomes and wouldn’t be changing plans as they are self employed, but there are a lot of other things to do before you’d need to look at this I imagine.
I think part of what makes it a good deal for the “deployed military doctors” is the tax exclusion for personal income up to a certain amount for each month that a military member has served in a combat zone. So their “after tax” contributions are actually tax free and it is a better deal to deposit those contributions in a TSP Roth account instead of a tax deferred TSP account.
I don’t see this anywhere near as controversial as some seem to.
There are a number of strategies widely in use today for “back door” Roth creation — suited for taxpayers who have incomes that exceed the Roth limit. At present, any traditional Ira can be converted to a Roth, even for those above the Roth limits. If you have no other traditional Ira accounts, you can do a traditional contribution and immediate Roth conversion without having to deal with allocating basis. Very attractive, frankly.
The rules about Roth conversions are black and white, not grey.
The laws passed allowing this sort of conversion were done very recently. I poured over the text of the regulations over and over again, consulted with my CA and it appears legit. I suppose there’s always some risk in your interpretation and reliance on various authorities. Short of seeking a private letter ruling you might never know for sure. But I’m all in on it.
This is actually very cool for me personally. The reason being I am investing locally in low end real estate and prefer to do that through an IRA account than straight cash. If the income can be tax free in retirement that is absolutely huge. The problem is the $5.5k + $5.5k contribution limits for a couple are just too low to make it work much – I’ve already largely used up all of my available IRA dollars. This would open up another $34.5k a year which here in Raleigh will let me buy one additional low end condo. I can get condos here in Raleigh at that price that yield $600+ a month after HOA fees. The math is not complicated to see how attractive that is particularly if you can build a portfolio of these in tax sheltered accounts
The laws allowing it aren’t a recent change. I did what pfd is proposing in the 2007/2008 timeframe. That was when I was with the only employer I’ve ever had that allowed for after-tax (but not Roth) 401k contributions. It was a little trickier back then as the final conversion (from Trad IRA to Roth IRA) after the rollover wasn’t allowed above certain income levels (these have since been removed).
The main things that changed from then to now is more flexibility in how you can convert traditional retirement accounts to a Roth IRA and the elimination of the income cap for said conversion.
I wrote a similar article to this on my Blog last month- While IRS has not ruled on in service withdrawals of post tax to IRA, they have issued guidance on in plan rollovers from Post Tax 401K to Roth 401K in same plan.
In Dec 2013, the IRS published the following guidance giving workplace plans the ability to grant in plan Roth rollovers for after tax 401K contributions.
http://www.irs.gov/Retirement-Plans/In-Plan-Roth-Rollovers-Expanded