Mega Backdoor Roth Strategy Saves Tech Exec $340K in Taxes
Executive Summary
This case study explores how Benjamin Chow, a financial advisor at Pacific Gate Capital, helped a high-income tech executive overcome limitations on Roth IRA contributions. The client, constrained by income restrictions, was unable to maximize tax-advantaged savings. Chow implemented a mega backdoor Roth strategy, facilitating after-tax 401(k) contributions and their immediate conversion to a Roth IRA. This strategy is projected to save the client an estimated $340,000 in taxes over a 10-year retirement period.
The Challenge
Our client, Mark Olsen, is a 45-year-old software engineering manager at a prominent tech company in the San Francisco Bay Area. His annual salary, consistently above $250,000, placed him well beyond the income limitations for direct Roth IRA contributions. For 2023, the contribution limit for single filers was phased out between $138,000 and $153,000, rendering direct contributions impossible. While Mark was contributing the maximum allowable amount to his traditional 401(k) ($22,500 in 2023), he felt he was missing out on the significant long-term tax advantages of a Roth account.
His existing retirement savings, primarily in a traditional 401(k) and taxable brokerage accounts, totaled approximately $750,000. He was concerned about the potential tax burden during retirement, especially given the likelihood of higher tax rates in the future. He desired a strategy to increase his Roth holdings and minimize future tax liabilities, effectively diversifying his retirement portfolio from a tax perspective. He had heard about the "backdoor Roth" strategy but his high income was over the pro-rata rule limitations. Therefore, the Mega Backdoor Roth strategy was a good alternative.
Adding to the complexity, Mark’s employer offered a 401(k) plan that allowed after-tax contributions, but with limited clarity on the conversion process. Plan documents were dense and difficult to interpret, making it challenging to determine the feasibility of a mega backdoor Roth strategy without expert guidance. The employer also did not readily provide the in-plan Roth conversion feature, which complicated the overall process. This meant that Mark would have to leave his job to take the distribution.
Mark was concerned that the small amounts he could contribute after-tax would be insignificant. However, Benjamin Chow quickly pointed out that it was not about the initial deposit, but the tax deferred (and eventually tax-free) growth.
The Approach
Benjamin Chow, recognizing Mark's desire for tax-advantaged growth, developed a tailored mega backdoor Roth strategy. This approach involved several key steps:
-
Plan Document Review: A thorough review of Mark’s employer's 401(k) plan documents was crucial. Benjamin meticulously examined the plan's provisions regarding after-tax contributions and in-service distributions. This was to ensure there was a way for Mark to access the funds after the after-tax contribution.
-
Contribution Limit Calculation: The annual 401(k) contribution limit (employee + employer contributions) for 2023 was $66,000. Given Mark's $22,500 pre-tax contribution, he could potentially contribute an additional $43,500 in after-tax contributions.
-
Conversion Feasibility Assessment: Benjamin investigated the availability of in-plan Roth conversions within Mark's 401(k) plan. This would allow immediate conversion of after-tax contributions to a Roth account, minimizing potential tax implications on any earnings generated before the conversion.
-
Coordination with Employer: Direct communication with Mark's employer’s HR department and benefits administrator was essential. This ensured a clear understanding of the plan’s rules and procedures for after-tax contributions and conversions. Benjamin had to explain why Roth in-plan conversions should be enabled in the plan for all employees.
-
Tax Impact Analysis: A detailed tax analysis was performed to project the potential tax savings of the mega backdoor Roth strategy over Mark's retirement. This involved estimating future tax rates and investment growth rates.
-
Long-Term Projections: The goal was to show Mark the potential benefit of this strategy. With conservative growth estimates, Benjamin demonstrated that these after-tax contributions could compound, creating substantial tax-free assets over the long term.
Benjamin carefully explained the pro-rata rule and how it would not affect Mark because he had little to no pre-tax funds in any IRA.
Technical Implementation
The implementation of the mega backdoor Roth strategy required a combination of financial expertise, technical tools, and meticulous record-keeping:
-
Contribution Tracking: Mark implemented a system for meticulously tracking all after-tax contributions to his 401(k). This was crucial for accurately reporting conversions and avoiding double taxation.
-
Roth Conversion Execution: With the after-tax contributions made, Benjamin facilitated the Roth conversion process. This involved completing the necessary paperwork and ensuring that the funds were transferred directly from the 401(k) to a Roth IRA in a timely manner to minimize any earnings that might accrue between contribution and conversion.
-
Software Utilization: Benjamin used specialized Roth conversion analysis software to model different scenarios and optimize the conversion strategy. This software considered factors such as current and projected tax brackets, investment growth rates, and retirement income needs.
-
Excel Modeling: Custom Excel models were developed to project the long-term tax savings of the mega backdoor Roth strategy. These models incorporated assumptions about investment returns, inflation, and tax rates, allowing for a comprehensive assessment of the strategy's financial impact. The models used compounded interest formulas to account for the effects of long-term growth within the Roth IRA.
-
Tax Form Preparation: Benjamin assisted Mark with the preparation of tax forms related to the Roth conversions. This included Form 8606 (Nondeductible IRAs) for reporting the after-tax contributions and conversions.
Results & ROI
The mega backdoor Roth strategy yielded significant tax savings for Mark:
-
Projected Tax Savings: Over a 10-year retirement period, the strategy is projected to save Mark an estimated $340,000 in taxes, assuming an average annual investment return of 7% within the Roth IRA and a marginal tax rate of 25% during retirement. This estimation was determined by calculating the difference between the tax liability Mark would have faced if the same amount was held in a taxable account versus the tax-free growth and withdrawals from the Roth IRA.
-
Roth IRA Growth: By consistently contributing the maximum allowable after-tax amount ($43,500 in 2023, adjusted for inflation in subsequent years) and converting it to a Roth IRA, Mark is projected to accumulate over $600,000 in tax-free retirement savings within 10 years.
-
Diversified Tax Portfolio: The mega backdoor Roth strategy helped Mark diversify his retirement portfolio from a tax perspective, reducing his reliance on taxable accounts and traditional 401(k) distributions.
-
Increased Financial Security: The tax-free growth and withdrawals from the Roth IRA provided Mark with greater financial security and flexibility during retirement. He could access these funds without incurring any federal income taxes.
-
Immediate Tax Efficiency: Although the contributions were made with after-tax dollars, the immediate conversion to a Roth IRA minimized potential taxes on earnings generated before the conversion.
Key Takeaways
-
Maximize Roth Opportunities: Even high-income earners can benefit from Roth accounts through strategies like the mega backdoor Roth. Understanding and utilizing these strategies can significantly enhance long-term tax-advantaged savings.
-
Thorough Plan Review is Essential: A comprehensive review of 401(k) plan documents is crucial for identifying opportunities for after-tax contributions and Roth conversions. Don’t assume that the plan doesn’t allow it – dig deeper.
-
Collaboration is Key: Effective communication and coordination with employers and benefits administrators are essential for successfully implementing a mega backdoor Roth strategy.
-
Use Tax Projection Tools: Employing Roth conversion analysis software and Excel models can help advisors project the long-term tax benefits of the strategy and optimize its implementation.
-
Meticulous Tracking is Mandatory: Accurate tracking of after-tax contributions and Roth conversions is crucial for tax reporting and avoiding double taxation.
About Golden Door Asset
Golden Door Asset builds AI-powered intelligence tools for RIAs. Our platform helps advisors identify hidden wealth-building opportunities for their clients and optimize their tax planning strategies. Visit our tools to see how we can help your practice.