Why Are Backdoor Roth and Mega Backdoor Roth ‘Loopholes’ Allowed?

We’re going to kick it off with the question from Aaron. He says, “I hear Brian say Roth accounts are so good that the government limits who can contribute to it based on income.” He’s definitely listened to you, Brian. But the question is, then why is there a backdoor and a Mega Roth? And also, how does one use the backdoor and the Mega Roth? Because if it’s so good, he’s learning some details on these backdoor options. What do you think?

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Well, let me… Can I speak to… I’ll speak to why is it there, and then you can kind of speak to how do you do it, how to use it. How’s that sound? So the “why is it there?” Well, a lot of times when legislation is passed or legislation is created, they don’t exactly recognize all the different conduits, all the different… I’m going to use the term backdoors or loopholes that may exist. Well, what ended up happening, I don’t think the backdoor Roth conversion was ever meant to be a specific strategy. What it was is there has always been the ability for individuals to convert pre-tax dollars to Roth dollars. You could always do that. You could convert an IRA into Roths, and up until about 2010, you could only do that if your income was below $100,000. But then in 2010, the legislation changed, said, “Hey, even if you make over $100,000 of income, you can still do Roth conversions.” Well, just like financial mutants typically do, someone out there said, “Hey, you know what I could do? I don’t have any other IRA balances. If I were to do a non-deductible contribution and I don’t have to prorate any of my other IRA balances, is that kind of like a backdoor way for me to do a Roth IRA contribution?” And boom, the backdoor Roth was born. I don’t know that it was intentionally established to operate the way that it has, but yet here we are, and it is operating that way. It is something that is available but perhaps won’t be available forever.

Yeah, I mean, it was on when legislation, when they’ve had negotiations on budgets and new legislation, a lot of times this has been on the chopping block. Because they know that this loophole exists, some people don’t like it. So they’ve actually put it up to take it away, but it’s still there. So take advantage of it while it is. But you have to have the right structure; that’s the key thing. A lot of people, when we see this sometimes when prospects they come in, they say, “I’m doing the backdoor.” And then I find out they have a rollover IRA. Like, “No, you’re not really doing a backdoor. You’re basically just underreporting your income, and you’re really creating a horrible headache for yourself in the future because we have to unwind this. Now, so or figure out how do we fix this?” So make sure you have the right structure because that’s a big part of this. And that leads to the backdoor Mega Roth is kind of the same thing in the fact that the government has what’s called 415 limits. There’s an annual limit on how much you can contribute to 401(k) accounts; it’s around $66,000, that’s right. So, and that’s your employee contributions, $22,500 this year. And then you have, you know, and that leaves the rest of the room for your employer. But sometimes your employer is not using all of that 415 limits, so they added a third bucket, just like we have Roth contributions, we have pre-tax contributions, and then we have after-tax contributions. And it’s allowed that you can actually fill up the remainder of that 415 limit that’s unused by you and your employer, and you can make after-tax contributions, meaning you’re not getting a deduction on your tax return, it’s going in after tax. But then there’s this crazy, once again, structure set up to where if you allow in-plan conversions or conversions while you’re in-service, meaning you don’t have to retire to withdraw money from your retirement plan, then you can actually take those after-tax contributions and convert them into Roth contributions, hence Mega Roth opportunities because there’s a lot of room between $22,500 and the $66,000. Now, there is one caveat I got to tell you to be careful of: you can make the contributions throughout the year, and the government will let you, for the prior plan, you know, plan year. If you’ve already opportunities, that’s why the biggest thing is make sure you structure these huge things and these unique opportunities well. And that’s why this is a really cool opportunity that we do for a lot of our clients. You’ve never done this before; we’ve done this hundreds, if not thousands, of times for clients that let us help you navigate these things. That’s always when I talk about the abundance cycle. This is a perfect point when you’re doing these advanced planning things to graduate to the next level with the relationship. Love it. For more information, check out our free resources.