In the personal finance community, there’s a lot of back and forth between the advantages and disadvantages of Traditional and Roth IRAs. Short and long-term tax implications are normally highlighted as the main differences and are the ones that carry the heavyweight in moving the needle in either direction. Aside from understanding the tax implications, these accounts have different eligibility requirements that, as a result, could prohibit you from directly contributing to an account. This happens to be the case for Roth IRAs.

Roth IRA Rules

Guidelines to contribute to a Roth IRA are usually revised on an annual basis. As of 2018, you may only directly contribute to a Roth IRA account if your modified adjusted gross income (MAGI) is less than $135,000 for single filers and $199,000 for married couples filing jointly. The maximum annual direct contribution is $5,500 per person or $11,000 for a couple. If you are age 50 or over, then the amount increases to $6,500 or $13,000 per household.

If you are a high-income earner with a MAGI greater than $135,000 or $199,000 you still have an option to stash $5,500-$11,000 in a Roth IRA; however, you won’t be able to contribute directly, you will have to use the “Backdoor Roth IRA” conversion.

Backdoor Roth IRA Conversion

In general, this is a strategy that high-income earners may use to make Roth IRA contributions of $5,500/year per individual or up to $11,000/year per couple. The process is quite simple but it could get messy if you have multiple Traditional IRA accounts, why? because of tax implications. I highly recommend doing your due diligence and, if needed, talk to a tax advisor or accountant to make sure you make an informed decision. If you’re starting fresh and have no existing IRA accounts, then the process should be fairly simple.

When I heard about the backdoor Roth, I didn’t have any existing IRA accounts so I was pretty much starting from ground zero. Physician on Fire recently updated his post on the backdoor Roth IRA conversion in Vanguard. It is a very comprehensive step-by-step guide that should help you complete this process, especially if it is your first time. On a high level, the steps are the following:

1. Open a Traditional and Roth IRA accounts at Vanguard,
2. Make a non-deductible contribution of $5,500 to the Traditional account,
3. Wait a day or two for the funds to clear on the account,
4. Transfer the balance from the Traditional IRA to the Roth IRA account.
5. Repeat steps 1-4 for your spouse.

Even though the steps mentioned above were straightforward I would be lying If I said I was confident about the whole thing. In fact, it was the opposite. This was my first time doing the Backdoor Roth IRA conversion and despite the fact I read a ton of posts walking you through the strategy I did not want to screw up. As a result, I gave Vanguard a call and since they had published information about a backdoor Roth IRA conversion, they knew exactly what I wanted to do. They were very helpful in guiding me through their site so that I could complete the process. Once finalized, I was pretty much set for future years.

My wife and I are big fans of VTSAX but this fund requires $10,000 as a minimum investment. We decided to buy a target date retirement fund (TDRF) ($5,500 each) knowing that we would switch to VTSAX after contributing to our Roth accounts the following year. We’ve held VTSAX in both our Roth IRA accounts ever since.

In 2017, we took a pause and decided to pursue our first Mega Backdoor Roth IRA conversion. If this is somewhat confusing to you, no worries, I’ll go into more details later. For now, just consider the Mega Backdoor Roth as another option that might be available to you. Whether you pull the trigger or not depends on your particular situation.

Mega Backdoor Roth IRA Conversion

Leveraging tax-deferred vehicles such as 401(k), HSAs and IRAs is essential for reaching financial independence. Striving to maximize annual contributions of each of these buckets is easier said than done but if possible it enables time to be on our side and to allow our dollars to work on our behalf. The only downside, or perhaps limitation to this strategy (aside from having the ability to maximize annually) is the cap the IRS has set for each of this individual buckets. Below are the annual contribution limits for these accounts.

Plan	Single	Married filing jointly	Catch up
401(k)	$18,500	$18,500	+$6,000 (age 50)
HSA	$3,450	$6,850	+$1,000 (age 55)
IRA	$5,500	$5,500	+$1,000 (age 50)

When I read the Mad Fientist’s post on the Mega Backdoor Roth, I was immediately shocked by the amount someone could contribute to a Roth IRA on an annual basis. Being able to stash up to $36,500 in addition to $11,000 ($5,500×2 for a couple) was just unbelievable. I’ve been maxing out my 401(k) ever since I started working which has been great, but I can’t deny that finding out I could have contributed after-tax dollars to a 401(k) was painful.

The maximum 401(k) contribution limit in 2018 is set at $55,000 ($55,000-$18,500 = $36,500);  however, you need to do your homework to see if you have the option to capitalize on this strategy. Here are the basic steps I recommend following:

1. Confirm your ability to make after-tax contributions to your 401(k).
2. Understand your benefits, i.e. company match, pension plan, etc to estimate the after-tax contribution amount.
3. Try to front-load your after-tax contribution early in the year to minimize capital gains.

Setting Up My Strategy

My employer allows contributing Pre-tax (Traditional), Roth and After-tax dollars to our 401(k) so the key was to figure out all elements of my defined contribution plan to facilitate setting my contribution percentage(s) to maximize the limit at $55,000. In general, the math is the following:

After-tax Annual Contribution = $55,000 – A – B – C

A = $18,500,     B  = company match,     C  = other

In my case, my employer offers a 6% match and 4% for a pension plan. What made the math a little tricky was having a bi-weekly payment cycle (26 total payments in the year) coupled with annual bonuses and raises communicated at the end of Q1. Taking that into account was critical for the math to be spot on.

I ballparked my bonus (based on my salary grade) and then estimated (goal seek) what my pre-tax and after-tax contributions needed to be that in combination with the bonus would make me hit the after-tax limit at the end of Q1. One thing I should say is that I did not maxed out my pre-tax contribution ($18,500) because for one, our 401(k) provider caps all contributions at 30% and also because It didn’t make any sense to default the 6% match. As a result, I re-adjusted my pre-tax contribution to 6% and stopped making after-tax contributions.

Fidelity is my 401(k) provider so I decided to give them a call to get their support with the next steps. As it turned out, there was no need to set up a Traditional IRA as after-tax contributions within a 401(k) can be directly transferred into a Roth.

Initially, I thought about having Fidelity mail me a check to deposit my after-tax contributions at Vanguard (where I keep my Roth IRA); however, I decided to keep things simple (could be argued) by opening a Roth account with Fidelity and having them take care of the rest. I bought FSTVX, which is an index fund I’ve held in my investment portfolio for a while and is equivalent to Vanguard’s VTSAX. Last but not least, capital gains were minimal so no need to worry about taxes triggered by this conversion.

Considerations

The Mega Backdoor Roth IRA works great but it’s easy to see the window of opportunity closing as your income increases with time. It’s not only bad that we have to go through a loophole to contribute the $5,500 via a backdoor Roth but as the Table below shows, the more you make (which is great!!!) the less you can contribute after-tax dollars to your 401(k) plan. I’m not going to complain about an employer increasing their match or adding additional benefits as those represent free money that far outrun the benefits of after-tax contributions.

Final Thoughts

• My financial plan has consisted in maximizing all tax-deferred vehicles available at my disposal; however, the Mega Backdoor Roth is one I had never considered.
• Check with your employer to see if you have the option to contribute after-tax dollars to your 401(k).
• Understand all your benefits as they relate to your 401(k) defined contribution plan.
• If you want to maximize annual contributions to your 401(k), understand the guidelines, do the math and set your percentages accordingly.
• If you and your wife are both W-2 income earners you could be looking at a savings potential of $110,000 per year within your 401(k). This does not include the $11,000 for direct contributions to an IRA or the $6,850 to an HSA!.
• There’s a lot of debate between the advantages and disadvantages between Traditional and Roth accounts. I prefer contributing pre-tax dollars to my 401(k) but l love the idea of the mega backdoor Roth and being able to contribute a significant amount of money to a tax-deferred account.

So what do you think about this strategy? have you taken advantage of it?.

Until next time … JJ