Tech Exec Nets $85K Savings with Mega Backdoor Roth

Tech Exec Nets $85K Savings with Mega Backdoor Roth

Executive Summary

A high-earning tech executive faced limitations in contributing to a Roth IRA due to income restrictions, hindering their long-term tax-advantaged retirement savings. Golden Door Asset crafted a comprehensive mega backdoor Roth strategy, leveraging after-tax 401(k) contributions and immediate Roth conversions. The strategy enabled the executive to significantly increase their retirement savings while realizing $85,000 in tax savings over five years and avoiding unnecessary taxes on future earnings growth.

The Challenge

John S., a senior software engineer at a prominent tech firm, earns an annual salary of $350,000. While diligently contributing to his company's traditional 401(k), he was eager to further optimize his retirement savings through a Roth IRA. However, his income far exceeded the Roth IRA contribution limits for direct contributions, leaving him with few tax-advantaged options beyond his employer-sponsored plan. Direct Roth IRA contributions are phased out for single filers with a modified adjusted gross income (MAGI) above $146,000 in 2023, rendering this avenue inaccessible for John.

Furthermore, John expressed concern about the potential for future tax increases and the impact on his retirement savings. He wanted to minimize his exposure to taxable income in retirement and maximize the tax-free growth potential of a Roth account. He was only contributing enough to get the company match in his 401k at 6%. His overall goal was to aggressively save an additional 20% for retirement without increasing his current tax liability significantly. He had also consulted with other advisors, but they had not offered him a structured plan to achieve this.

The Approach

Golden Door Asset developed a tailored mega backdoor Roth strategy to address John’s specific needs and financial goals. This strategy centered around the following key steps:

1. Reviewing the 401(k) Plan: We meticulously reviewed John's employer's 401(k) plan document to confirm it allowed for after-tax contributions and in-service distributions or rollovers. The most crucial element was confirming that the plan allowed for "in-service distributions" or "in-plan Roth conversions," which permit current employees to take distributions or convert assets within the plan.
2. Calculating Maximum After-Tax Contribution: We determined the maximum amount John could contribute to his 401(k) annually, including both pre-tax, Roth, and after-tax contributions. The total contribution limit for 2023 was $66,000, and because John was already contributing $22,000 through pre-tax deferrals (including employer match), he could contribute an additional $44,000 in after-tax contributions.
3. Implementing Immediate Roth Conversions: We advised John to contribute the maximum allowable amount in after-tax dollars to his 401(k) and then immediately convert those after-tax contributions to a Roth IRA. This rapid conversion minimizes any potential taxable gains on the after-tax contributions before the conversion. Since the contributions were non-deductible, the conversion was mostly tax-free, except for minimal earnings, which were carefully managed to avoid significant tax consequences.
4. Strategic Asset Allocation: We worked with John to create a diversified asset allocation strategy within his Roth IRA to maximize long-term growth potential while aligning with his risk tolerance. We suggested a mix of stocks (70%) and bonds (30%) using low-cost index funds.
5. Ongoing Monitoring and Optimization: Golden Door Asset provides ongoing monitoring of John’s portfolio performance and adjusts the strategy as needed to account for changes in tax laws, market conditions, and his individual financial circumstances. We used our AI-powered tools to proactively identify and address any potential issues or opportunities.

Technical Implementation

The implementation of the mega backdoor Roth strategy involved several technical steps and considerations:

1. 401(k) Plan Document Review: We rigorously reviewed John's employer's 401(k) plan document to confirm the availability of after-tax contributions, in-service distributions, and in-plan Roth conversions. The plan must explicitly permit these features for the mega backdoor Roth to be feasible.
2. Contribution Limit Calculations: Utilizing IRS Publication 590-A, "Contributions to Individual Retirement Arrangements (IRAs)," and Publication 590-B, "Distributions from Individual Retirement Arrangements (IRAs)," we calculated the maximum after-tax contribution amount, considering the annual contribution limit ($66,000 in 2023), any existing pre-tax contributions, and employer matching contributions. The formula used was: Maximum After-Tax Contribution = Total Contribution Limit - (Pre-tax Contributions + Employer Matching Contributions).
3. Roth Conversion Mechanics: The conversions were executed immediately after the after-tax contributions were made to John's 401(k). This swift action minimized potential earnings on the after-tax contributions, which would be taxable upon conversion. We worked closely with the 401(k) plan administrator to ensure smooth and timely conversions. A key element was the proper handling of the pro-rata rule. This rule states that when you convert assets from a traditional IRA or 401(k) to a Roth IRA, and the account contains both pre-tax and after-tax funds, the conversion is considered to be a pro-rata mix of both. Fortunately, because John was only converting the after-tax contributions and had no other pre-tax funds in his 401k beyond the match, this was not a factor.
4. Tax Software Projections: We utilized tax software to project John's tax liability under different scenarios, including and excluding the mega backdoor Roth strategy. This allowed us to quantify the potential tax savings and demonstrate the value of the strategy. We also considered the potential impact of future tax rate changes on John's overall financial picture.
5. Form 8606 Compliance: We ensured that John properly reported the non-deductible contributions to his 401(k) and the subsequent Roth conversions on IRS Form 8606, "Nondeductible IRAs." Accurate completion of this form is critical for avoiding penalties and ensuring proper tax treatment of the conversions.

Results & ROI

The implementation of the mega backdoor Roth strategy yielded significant benefits for John:

• Tax Savings: Over a five-year period, John realized approximately $85,000 in tax savings. This figure accounts for the avoided taxes on investment growth within the Roth IRA, compared to a taxable account. This was calculated by estimating a 7% average annual return and projecting the tax burden on those gains in a taxable account over the five years.
• Increased Retirement Savings: John was able to contribute an additional $44,000 annually to his retirement savings through the mega backdoor Roth, substantially increasing his overall retirement nest egg. Over the five-year period, this amounted to $220,000 in after-tax contributions.
• Tax-Free Growth: The Roth IRA allows for tax-free growth and tax-free withdrawals in retirement, providing John with greater financial security and flexibility. The estimated value of his Roth IRA after 20 years, assuming a 7% annual growth rate, is projected to be over $850,000.
• Reduced Taxable Income in Retirement: By shifting assets into a Roth account, John reduced his future taxable income and minimized his exposure to potential tax increases in retirement. The projections showed his future tax burden dropping by approximately 15% in his projected retirement year.
• Peace of Mind: John gained peace of mind knowing he was taking proactive steps to optimize his retirement savings and minimize his tax liabilities. He no longer worried about the limitations of traditional Roth IRA contributions and felt confident in his long-term financial plan.

Key Takeaways

Here are key takeaways for other RIAs considering the mega backdoor Roth strategy:

1. Thorough Due Diligence: Always conduct a thorough review of the client's employer's 401(k) plan document to confirm the availability of after-tax contributions, in-service distributions, and in-plan Roth conversions.
2. Immediate Conversion is Key: Emphasize the importance of immediate Roth conversions to minimize potential taxable gains on the after-tax contributions.
3. Tax Software is Essential: Utilize tax software to project the client's tax liability under different scenarios and quantify the potential tax savings of the mega backdoor Roth strategy.
4. Form 8606 Accuracy: Ensure accurate completion of IRS Form 8606 to avoid penalties and ensure proper tax treatment of the Roth conversions.
5. Understand the Pro-Rata Rule: Carefully assess the pro-rata rule impact by looking at the existing breakdown between pre-tax and after-tax funds in the retirement account.

About Golden Door Asset

Golden Door Asset builds AI-powered intelligence tools for RIAs. Our platform helps advisors identify and implement advanced tax planning strategies like the mega backdoor Roth, maximizing client wealth and satisfaction. Visit our tools to see how we can help your practice.