Securing retirement in the USA - Part2
In Part1 of this series, we have discussed 401k, Traditional IRA and a bit on Roth IRA accounts. We also discussed how HSA account can be used as retirement account. But we haven't discussed how to work around the income limits on Roth IRA accounts. In this article we will discuss the following topics.
- Backdoor Roth IRA
- Mega Backdoor Roth IRA
- Differences between 401k Roth and separate Roth Account
Backdoor Roth IRA
A Roth IRA is funded with post tax money, but the earnings grow tax free, and you will not pay taxes during retirement. In 2023, for those married filing jointly, if the income is more than $228k, you are not eligible to contribute to Roth IRA. But the income limit doesn't apply to conversions. So, irrespective of your income, you can convert $6500 into your Roth IRA every year. The way to do this is to contribute $6500 to tradition IRA and as soon as you have the money in traditional IRA account, convert into Roth IRA.
If you are doing this through financial institutions like fidelity, it's straightforward. You can open one traditional and one Roth IRA account online and then transfer funds to traditional IRA. As soon as the funds are available in traditional IRA, move them to Roth IRA.
Mega Backdoor Roth IRA
In 401k account, we can make post tax contributions and then do an in-plan conversion to Roth IRA. Although this doesn't create a separate Roth IRA account, that portion of the 401(k) is designated as Roth. To do this, your 401k plan should allow 2 things.
- Post tax contributions
- In-plan conversion
After making post-tax contributions, ensure the in-plan conversion is executed before the money gets invested. If you miss the in-plan conversion, then the earnings on the investments will be taxed while conversion. If you have 401k with financial institutions like Fidelity, you can setup automatic conversion of your post tax contributions to 401k Roth.
Why is this called mega Backdoor Roth?
It's called mega because we can contribute huge amount to Roth in this method. In 2023, for individual less than 50 years, we can contribute up-to $66k to 401k. But this amount includes your pretax contribution , employer match. post tax contributions and any other Roth contributions. Assuming you maxed out your pretax 401k and also has separate Roth IRA where you contributed $6500, let's calculate how much more you can contribute using mega backdoor Roth.
- Total IRS contribution limit for all types of retirement plans: $66,000
- Minus pre-tax 401(k) contribution: $22,500
- Minus employer matching contribution: $5,000
- Minus Roth IRA contribution: $6,500
- Remaining mega backdoor Roth contribution limit: $32,000
Differences between 401k Roth and separate Roth Account
With respect to withdrawals, you have more flexibility in separate Roth account when compared to 401k Roth. The 401k Roth money can't be withdrawn until retirement(59 and half years) without penalty. With Roth IRA, you can withdraw your contributions anytime without taxes and penalty. To withdraw the earnings without penalty you need to wait till the retirement.
Also, separate Roth account offers wider investment choices when compared to 401(k) Roth.
That's a wrap for this week !! Happy learning.
Please note that, I am not a financial advisor or tax consultant. I write based on my own research, experiences and interviewing the people done these things. So, be aware of the options and discuss with your tax consultant to make right decisions for your financial situation.
