Planning for retirement is an essential pillar of financial success. The financial landscape offers an array of tax-efficient tools to help achieve this goal—401(k)s, HSAs, IRAs, Roth IRAs, and more. However, high-earning young professionals often find themselves in a challenging position. Their substantial salaries and equity compensation frequently place them in high tax brackets, yet the presence of income limits on accounts like Roth IRAs can be a roadblock. Fortunately, high-earning young professionals can surmount these income limits through Backdoor and Mega Backdoor Roth Conversions. These methods allow them to bypass these restrictions and substantially reinforce their retirement savings.
Understanding Roth IRAs
A Roth IRA is a type of individual retirement account that offers tax-free withdrawals in retirement. Unlike traditional IRAs, contributions to a Roth IRA are made with after-tax dollars, which means you won’t get an immediate tax deduction. However, the growth and withdrawals from a Roth IRA are tax-free, making it an attractive option for those who expect to be in a higher tax bracket in retirement.
Advantages of Roth IRAs
For high-earning young professionals, Roth IRAs provide several advantages:
- Tax Diversification: Roth IRAs complement traditional retirement accounts, such as 401(k)s and traditional IRAs, by providing a source of tax-free income in retirement.
- No Required Minimum Distributions (RMDs): Roth IRAs do not have RMDs, allowing you to keep your money growing tax-free for as long as you wish.
- Flexible Withdrawals: Contributions to a Roth IRA can be withdrawn at any time without penalties or taxes, providing a degree of flexibility for emergencies or major life expenses.
Contribution Limits and Income Restrictions
As of 2023, the IRS guidelines state that individuals under 50 can contribute up to $6,500 per year, while those 50 and older can contribute up to $7,500 per year. However, there are income limits that restrict high-earners from contributing directly to a Roth IRA. Single filers with adjusted gross income above $153,000 and married filers above $228,000 are prohibited from making any contributions. This is usually the main hurdle for tech employees (and the reason why Backdoor Roth Conversions can be a useful tool).
Tax Benefits of Roth IRAs in Retirement
In retirement, qualified withdrawals from a Roth IRA are entirely tax-free, providing a substantial benefit to individuals who anticipate paying higher taxes during retirement.
Backdoor Roth Conversions
A Backdoor Roth Conversion is a strategy for high-earning individuals to get around the income limits mentioned above and contribute to a Roth IRA indirectly. It involves the following steps:
- Opening a Traditional IRA: Start by opening a Traditional IRA account.
- Making Non-Deductible Contributions: Contribute funds to your Traditional IRA without taking a tax deduction, as your income exceeds the limit for direct Roth IRA contributions.
- Converting to a Roth IRA: After making non-deductible contributions to your Traditional IRA, convert the funds to a Roth IRA. Since you didn’t take a tax deduction when contributing, you won’t owe taxes when converting.
Many brokerages, such as Charles Schwab, actually have dedicated workflows for Roth conversions just to make the process easier for users.
One thing that’s important to note here – if you earn any money on your contribution before converting it to a Roth (say, you invest it in a stock that goes up before converting), then the earnings will be taxable. We usually recommend that our clients do the contribution and the conversion in the same session to avoid scenarios like this.
Tax Implications and Considerations
While Backdoor Roth Conversions offer a fantastic way to get money into a Roth IRA, there are some tax-related considerations to keep in mind:
- Pro-Rata Rule: If you have other pre-tax IRAs (like a rollover IRA from a 401(k)), the IRS will consider all your IRAs when calculating taxes on a conversion. This can complicate the process, so it’s essential to be aware of the pro-rata rule.
- Tax Reporting: Properly report the Backdoor Roth Conversion on your tax return to ensure you don’t face any issues with the IRS.
Benefits of Backdoor Roth Conversions for Young Professionals
Young professionals with high earning potential can benefit from Backdoor Roth Conversions in the following ways:
- Get Around Income Limits: The primary benefit is that a Backdoor Roth Conversion allows you to skirt around the normal income limits for IRA contributions, allowing you to get more tax-advantaged money invested.
- Tax Diversification: Building a tax-free income stream for retirement alongside traditional retirement accounts.
- Long-Term Growth: Allowing your contributions and earnings to grow tax-free for decades.
- Financial Flexibility: Accessing contributions (not earnings) without penalty in emergencies.
- No RMDs: Avoiding mandatory withdrawals in retirement.
Mega Backdoor Roth Conversions
A Mega Backdoor Roth Conversion is an advanced retirement savings strategy. It allows you to contribute significant amounts to your Roth IRA through your employer-sponsored retirement plan, such as a 401(k). Here’s how it works:
- Maximizing Pre-Tax Contributions to Your 401(k): Contribute the maximum pre-tax contribution allowed amount to your 401(k) plan. As of 2023 this is $22,500 for those under 50, or $30,000 for those 50 and older.
- Contribute Post-Tax Dollars to Max Out the Plan: As of 2023, the total contributions to a plan are limited to $66,000. After your own contributions and your employers’ match, you can contribute post-tax dollars to hit that limit.
- In-Service Withdrawals: Check if your employer’s 401(k) plan allows in-service withdrawals of after-tax contributions. Not all plans offer this option.
- Conversion to a Roth IRA: If permitted by your plan, move the after-tax contributions into a Roth IRA, where they can grow tax-free.
Mega Backdoor Roth Conversions can be complex and nuanced, so we strongly recommend you speak with your financial or tax advisor first!
Tax Implications and Considerations
Mega Backdoor Roth Conversions come with their own set of tax rules and considerations:
- Pre-Tax and After-Tax Contributions: Understand the distinction between pre-tax, Roth, and after-tax contributions in your 401(k) plan.
- Limits and Restrictions: Ensure you stay within IRS contribution limits and that your plan allows for in-service withdrawals and conversions.
Benefits of Mega Backdoor Roth Conversions for High-Earning Tech Professionals
For high-earning young professionals, Mega Backdoor Roth Conversions offer significant advantages:
- Huge Contribution Potential: You can contribute a substantial amount of after-tax money to your Roth IRA, turbocharging your retirement savings.
- Tax Diversification: Balancing pre-tax and Roth retirement accounts for tax flexibility in retirement.
- No RMDs: Avoiding mandatory withdrawals and preserving tax-free growth.
Potential Challenges and Risks
While these strategies can be highly beneficial, they are not without risks:
- Tax Consequences: Mishandling conversions or not complying with rules can lead to unexpected tax bills.
- Complexity: The rules and regulations surrounding these strategies can be intricate, so it’s crucial to understand them fully.
- Impact on Other Goals: Consider how these strategies align with your other financial goals and priorities.
Tax Planning and Professional Assistance
Given the complexity and potential tax implications, consider working with a financial advisor or tax professional. They can help you navigate the intricacies of Backdoor and Mega Backdoor Roth Conversions and integrate them into your overall financial plan.
Conclusion
Backdoor and Mega Backdoor Roth Conversions are powerful tools that can help high-earning young professionals secure their financial future and build a tax-efficient retirement income stream. By understanding the rules, benefits, and potential challenges, you can make informed decisions aligned with your long-term financial goals. Remember that tax laws and regulations change, so it’s crucial to stay up-to-date and consult with financial professionals as needed.
Proventus Wealth does not provide specific legal or tax advice. Please consult with professionals in these areas for specific legal and tax recommendations. The information provided herein is general information. It is not intended to be construed as investment, tax, or legal advice. Information in this article is not an offer or solicitation to purchase, sell, or endorse a specific company, security, investment vehicle or strategy. Investing involves risk and the possible chance for loss of principal. Please consider your tolerance for risk before investing. Past performance is never guaranteed and future results can vary. Opinions conveyed by Proventus Wealth cannot be viewed as an indicator of future performance and are subject to change. Results may vary. Use information at your own risk.
