Dear Fix My Portfolio,
I have access to an after-tax 401(k) contribution through work with an in-plan Roth rollover.
I maximize my pre-tax contributions and use the mega backdoor contributions. I have enough saved in my pre-tax retirement accounts when I retire. I will need to transfer some to Roth accounts to help minimize my required minimum distribution amounts and annual retirement income. Since I plan to retire early, I have time to do that while I’m in a lower tax bracket. I was recently advised to save money outside of a retirement account instead of in the backdoor Roth.
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The theory is to use non-pension funds to pay the taxes on the rollovers and let the Roth continue to grow tax-free. I don’t understand why it’s better to save outside of the Roth for taxes when I could use the Roth for taxes (or the 401(k) for taxes). It looks like I’m now going to pay profits into the non-retirement accounts while I’m in a higher tax bracket, and if I use the mega backdoor Roth, I don’t have to pay profits and I can still use the same amount for taxes. What am I missing? I am looking for a second opinion.
Taxpayer
Dear taxpayer,
What you’re missing is that you’re in the middle of a retirement marathon, and the strategy you’re talking about measures in inches.
Try to take a step back and look at the big picture. Guide your actions based on your goals, rather than the taxes involved. I’ve talked to many experts about Roth conversions over time, and they always came to the same conclusion: Don’t let taxes dictate your money management decisions.
Roth conversions are when you put money into a pre-tax account like a 401(k), pay taxes on it, and then roll it straight into a Roth account that will grow tax-free. So you pay tax now or later. This will be a choice you have to make a lot. Taxes are a factor in every financial decision, and you can do your best to keep the amount you pay as low as possible, but they shouldn’t be the driving force behind what you choose to do.
It seems like your goal is to retire early. With that in mind, you’ll want to focus on maximizing your savings while you’re still working. Everything about how to do this is up for debate, and it can be confusing. You can get a second opinion, and a third, and they can all be different. One path may seem less today and turn out to be more down the road because tax law or your situation changes. No math is certain. The only thing that is certain is that the government will get its taxes at some point – it’s just a matter of when.
In the current economic climate, the theory behind what you do with mega backdoor Roth conversions and what you have been advised about paying taxes out of savings is sound. The reason behind this is to maximize the amount of money you can convert into a Roth account, allowing the growth to be tax-free from then on. Transferring your money to a Roth also provides a tax benefit for your heirs. They will have ten years to enjoy tax-free distributions and growth, and then they will transfer the money to a taxable brokerage account.
If you were to pay the tax due on a conversion with money from the conversion itself, you could simply put less into the Roth. If the whole point of paying taxes now is to get as much as possible into a Roth account, then you’ll want to follow through.
The same principle applies to what you do with mega backdoor Roth conversions. This is a complicated extra step that allows you to put as much as possible into a Roth account so that growth isn’t taxed in the future. You’re betting that your tax rate will be lower in the future, and that Roth accounts will continue to offer these tax benefits.
It may seem like you’re doing this for tax purposes, but your first priority is actually to set aside as much as you can while you work to fund your early retirement. The tax code you benefit from is actually the 401(k) contribution limitation.
Most people consider the current $23,000 limit for employees — plus the $7,500 allowed for catch-up contributions for those over 50 — as the end of the story. Most people don’t even come close to those amounts on an annual basis. But there is another limit: $69,000 in 2024 (or $76,500 for people age 50 and older). That is for employee plus employer contributions. For example, if your employer provides a 6% match, there will be room under that ceiling. A mega backdoor Roth conversion allows employees to make maximum after-tax contributions to their 401(k) and then immediately transfer the money to a Roth account, as long as the company allows in-plan conversions like yours.
The real benefit of this isn’t necessarily the reduction in future taxes, but it will help you set aside a significant amount of money for retirement. If you think about it that way, it’s less confusing and you can have less doubt about whether you’re doing it the “right” way. You are already ahead of the curve and are putting as much as possible into your pension kitty.
One last thing to consider is the five-year rule. This only applies if you are younger than 59½. If you’re investing as much as possible in Roth accounts because you plan to retire early and want to access money without a tax penalty before you turn 59½, you’ll want to make sure you start early enough so that you can keep the account open for five years. before you have to touch the money. If easy access is your goal, it may be more efficient for you to save more in a taxable brokerage.
