Episode 27

What’s the ‘Mega’ in Mega Backdoor?

October 15, 2022

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Welcome to The Retirement Tax Podcast, where hosts Steven Jarvis, CPA, and Benjamin Brandt, CFP, work together to bridge the gap between tax professionals, financial advisors, and their mutual clients to help reduce most people’s largest expense in retirement: taxes. Each week, they will dive into conversations around taxes, focusing on what you can truly control (instead of what you cannot) and how to set yourself up financially for your future.

Have you been reading about the mega backdoor Roth in articles or seeing it gracing headlines frequently? In this episode, Ben and Steven will be sitting down to chat about what all the hubbub is about and where you should probably be looking when aiming to max out your contributions. They give simple, actionable ways you can contribute more and how to best contribute.

Although Ben and Steven will not be going into the specific mechanics of how the mega backdoor Roth works, you will hear what you should be doing before ever getting to the point of doing one. No matter how nice a headline may be, you’ll learn the importance of looking at all the different pieces and accounts before deciding which to focus on.

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What You’ll Learn In Today’s Episode:

  • Why the mega backdoor Roth may not be worth all the hype.
  • The allure of the mega backdoor Roth.
  • What often gets missed when dealing with limitations.
  • Where to start looking when aiming to max out contributions.
  • Interesting characteristics of the mega backdoor Roth.
  • HSA accounts and the value of investing in them.
Ideas Worth Sharing:

“There are some neat things we can do that should probably take priority over the more exciting sounding things like the mega backdoor Roth.” –  Benjamin Brandt

“The allure of a mega backdoor Roth is potentially getting $60,000 into Roth accounts within a single year.” – Steven Jarvis

“There are no income limitations for contributing to a Roth within a 401(k).” – Steven Jarvis

Resources In Today’s Episode:
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Read The Transcript Below:

Steven Jarvis:     Hello everyone, and welcome to the next episode of the Retirement Tax Podcast. I am one of your hosts, Steven Jarvis, CPA. And of course, here with me is the incredible Benjamin Brandt. Ben, welcome to the show again.

Benjamin Brandt:         Always happy to be recording with you, Steven. I always look forward to these times. I learn a lot and I have a lot of fun. So, what more can a guy ask for?

Steven Jarvis:     Yeah, it is a good time. I’m actually really excited. As we’re recording this, in just a week, we’re going to be together in person again. That’s always fun. And as we’re just over a year into this, we’ve only still been together in person a couple of times, so it’s fun to be able to share this expertise over a podcast.

Benjamin Brandt:         That’s true. You’ve never been to Bismarck and I’ve never been to Seattle, but when we’re together, it’s always in different places. So, it’s interesting. Maybe someday I could come check out the wonder that is Bismarck, North Dakota.

Steven Jarvis:     Ben, I’m four hours east of Seattle and Spokane, anyways, but we’ll move on from our geography lessons for the day.

So, the topic for today, we want to talk about mega backdoor Roth. And the reason we want to talk about this is because it makes really fancy headlines and we see articles about it all the time.

And we’re not actually going to go into really specifics on the mechanics of how mega backdoor Roth works, because really, a lot of times the headline distracts from other things that we should be doing before we ever get to that point.

Benjamin Brandt:         Yeah. But it’s got such an attractive name. We see a blog post entitled, Mega Backdoor Roth Sky. I like a Roth and I like things that are super-sized, I want to learn more. But there are some neat things that we can do that probably should take priority over exciting sounding things like that.

Steven Jarvis:     Yeah, because the kind of the allure of the mega back door Roth is potentially getting $60,000 into Roth accounts in a single year, which for our listeners, I’m sure you’re very well aware that if we’re just putting directly into a Roth, we only can get to $6,000 per taxpayer, $7,000 if we’re eligible for the catch-up.

And so, $60,000 sounds really appealing, but we don’t want to get distracted by the flashy numbers. We want to focus on what works in practice and what’s actually going to help us move forward.

So, the starting point for me, as I work with clients on this topic is, okay, let’s look at, are we actually maxing just our regular 401(k) contributions, specifically our Roth 401(k) contributions. Because the end goal of a mega backdoor Roth is getting money into that tax-free bucket that we all love so much.

But what sometimes gets missed is that, while there are income limitations on putting money into a Roth account outside of a 401(k), there are no income limitations on contributing to Roth within a 401(k).

So, regardless of what income threshold we’re at, if you’re participating in a 401(k) plan for 2022, you can contribute up to $20,500 in Roth dollars into this 401(k) and skip all of that backdoor stuff.

And so, that’s always the very first thing I look at, is are we starting with the basics? Have we maxed out our Roth contributions?

Benjamin Brandt:         And so, no income limitations on the Roth 401(k). Now, if we’re getting a match from our employer, that’s not going into the Roth 401(k) section, is that right?

Steven Jarvis:     Yeah. That’s a really great reminder for all our listeners that even if you are contributing Roth to your 401(k), any match or profit share that your employer does, that’s going to be pre-tax dollars.

And usually, where this trips people up is when they go to retire or roll those funds into another account, start withdrawing them. For some people, that’s the first time they realize, “Wait, I still owe taxes on some of that balance.”

Because one of the things we love about Roth is that it essentially takes the IRS out of our investment accounts, because if we look at a Roth account balance and it says we have a million dollars, great. If I want to withdraw a million dollars tomorrow, assuming I’m over the age for penalties, great, I can take a million dollars and do what I want with it.

But if it’s in pre-tax, if it’s in traditional 401(k), if it’s in a traditional IRA, the IRS is going to take their portion first along with the state depending on where you live.

And so, that’s the appeal of those Roth dollars. But like I said, before we get to any backdoor anything, regardless of our income level, we get a 20,500. And that’s per taxpayer.

So, for a married couple who are both working and both have access to 401(k) plans, we’re potentially talking about $41,000 in Roth contributions, inside a 401(k) before we’ve talked about backdoor anything.

Benjamin Brandt:         And I guess it makes sense when we think about that employer match. Because we’re putting in money that is going to be tax and it’s going to grow tax-free, but our employer isn’t necessarily on that same plan that we’re on.

They do want the deduction. I don’t know if that’s how it works in reality, but when we make a match for our employees, we’re not paying income tax on that. So, it works that way.

Now, if we think about the conversions of the mega back door Roth, we probably want to, in step number one, clean up any IRAs that we have, some pre-tax IRAs before we move on to the next step.

If we have any pre-tax IRAs out there, that’s going to change like the pro rata rule (I might be missing the exact verbiage). But we want to make sure that we don’t have any IRAs that are not Roth IRAs outstanding, if we want to do any of these big backdoor Roths.

Steven Jarvis:     Yes, this is one of the interesting characteristics of the mega backdoor Roth, is that since it’s within a 401(k) plan, the IRS actually does separate this out. So, where the pro rata rule comes in, is when we are doing, what I think of as a more traditional backdoor Roth.

So, the plain Jane backdoor Roth is let’s make non-deductible IRA contributions and then convert them to Roth. And in that case, if we have any other traditional IRA balances out there, we run into the IRS’s pro rata rule, and we end up paying taxes we might not have been expecting.

And so, that is one potential advantage of doing this all within a 401(k) plan, is that the IRS does look at that kind of in its own silo. Regardless of how nice-sounding a headline might be, we want to look at all of these pieces, all of these different accounts before we decide which one we’re going to focus on to move forward with.

So, if we get to the point where we’re saying, great, we are maxing out our Roth contributions in our 401(k) and we still have more funds we want to set aside in a tax advantage way, the next step I would take is looking at are we eligible for an HSA?

Because HSAs (Health Savings Accounts) are the most tax advantage account you can have. Obviously, there’s the limitation on being able to spend those dollars for medical purposes, but medical costs are second only to taxes for most people. So, definitely something we want to be saving for.

So, if we’re eligible for an HSA, definitely want to make sure that we are max-funding that to the best of our abilities. If we’re putting $40,000 into a Roth 401(k), we’re looking at what? Cash flow we have left to fund this HSA.

But really, we’re going through this order of operations of if we have more we want to contribute, start with that Roth 401(k), and then I’ll move on to that HSA to say, “Okay, are we really getting as many dollars into these great accounts as we possibly can?”

Benjamin Brandt:         And when we’re talking about the HSA, in this instance, we’re talking about using it as a Roth or using it as an investment. So, we’re probably going to invest those premium dollars.

So, you have to make that decision for yourself, “Am I going to put cash in my HSA and then leave it in cash because I think I’m going to take it out in the short-term to pay medical bills?” Or am I going to say, “This is essentially hands off except for emergencies and I am in fact going to invest.” Because if we do want some of the great tax benefits, we’re going to want some growth on that.

So, is this a super-size emergency fund situation where it’s going to be in cash or cash equivalents, or is this something that …

Personally, I invest mine, but with six kids, I understand that that’s rolling the dice, but so far so good. So, knock on wood.

Steven Jarvis:     Yeah. Great reminder there. And we’ve talked about HSAs on the podcast before, but to really get the full kind of triple tax advantage of an HSA, we need to contribute the money, we need to invest the money, and then we need to let it grow tax-free and then use it for medical expenses.

So, as we go down our order of operations, the next thing I would look at, again, if we’ve max-funded our Roth 401(k), if we’ve max-funded our has, then I’m going to look at, okay, can I just make more of these plain Jane, just the regular old backdoor Roth contributions.

And this is outside of our 401(k) account. This is where we do need to think about that pro rata rule. For each spouse, for a married couple, even if only one is working, we can contribute up to $6,000.

And if we’re over that income threshold, that’s going to be a non-deductible IRA contribution that we then convert to Roth. So, that’s our more traditional backdoor Roth contribution.

But again, for a married couple, there’s another $12,000, potentially another $14,000, when we talk about the catch-up contributions. So, now we’re getting close to $60,000 between these different buckets of money that we’re putting in these incredibly tax-advantaged accounts, these tax-free accounts really.

And then, once we’ve gone through all of those steps, that’s the point at which I’m going back to a client and saying, “Okay, now let’s look and see if this is something that’s available under your 401(k) plan to potentially try to do this mega backdoor Roth.” Because they’re not available everywhere. It depends on the specific plan.

Benjamin Brandt:         Yeah, that sounds fantastic.

Steven Jarvis:     Yeah, so if we’ve gone through all of those steps, then yep, at that point, a lot of times I’m helping clients reach out to their HR or their benefits department to understand what’s available, if there’s an option to do that mega backdoor Roth. Because if we funded all those other things and we still have more we want to put away, great, it’s a fantastic option.

But I guess the point in this conversation is let’s not get distracted by the nicest sounding headlines. Let’s look at those basic things or seemingly simple things, that are really going to move the needle as we do this over 5 or 10 or 20 years, setting ourselves up for the life we want to have in retirement.

Benjamin Brandt:         It’s the Occam’s razor of retirement planning. Let’s not neglect the simple thing just because it’s the simple thing. Let’s do the easy stuff first.

Steven Jarvis:     Yeah, absolutely. Now, related to this topic or related to at least the topic of Roth, we have a couple of different listener questions we want to address.

So, Ben, I’m going to throw the first one to you. Listener writes in and says, “We have 1.2 million between Roth IRAs, taxable IRAs and 401(k) money. We also have over a hundred thousand dollars in brokerage. Should we focus on putting more in brokerage than retirement, as we are getting closer to retirement?”

Benjamin Brandt:         Fantastic question. Kudos to you for saving up such a huge amount of money. I think it’s a really easy thing for financial advisors and CPAs (I’m definitely guilty of this) to overlook someone that’s saved up a half a million or a million or $2 million. You are in rarefied air when it comes to savers. So, just want to especially say kudos to you for saving up that much money. So, let’s be good stewards of it.

So, 1.2 million between Roth taxable IRAs and 401(k) money, and then a hundred thousand at brokerage, I would kind of look at some of the steps that Steven laid out. I want to look at getting the match, and then I want to look at maximizing the 401(k), then I want to look at max-funding the HSA. I’m going to go through those order of operations.

But if you’re saving a huge amount of money, I do kind of like the after-tax brokerage, maybe we’re calling it non-qualified kind of depending on the language you’re using, but those brokerage accounts.

There are some really fantastic things that we can do with brokerage accounts and it’s somewhere between pay as you go and tax-deferred, depending on if you’re investing in mutual funds or ETFs or individual stocks.

But if you’re an aggressive investor and you’re investing in individual stocks and you say, “I’m going to buy stock in my company and they don’t pay dividend and I’m just going to let it ride forever,” you have to be your own risk tolerance to do that.

But if you’re willing to do that, and you do see some great appreciation over 10 or 20 years, there’s some really amazing things that we can do playing with some of the capital gains, the carve outs out of the tax code, we can gift those appreciated shares to charity.

And then we don’t pay capital gains on that. And of course, we get a deduction for giving them to charity or we can fund our donor advised fund. Or we can do tax gain harvesting, tax loss harvesting. We can pair them with like Roth IRA distributions and we can pay hyper low or even potentially no capital gains when we do distribute those.

And God bless you, if you make it to the end of your life and you haven’t sold your stocks yet, as long as the laws don’t change, we can give those to our kids after our death and they would step into that cost basis. And if they sell right after we die, they don’t pay any income tax or capital gains tax at all.

So, a lot of really amazing things that we can do. I think it’s attractive just like we talked about in the opening segment to Roth IRAs, taxable IRAs, HSAs, mega backdoor Roth, but don’t sleep on the just plain vanilla after-tax brokerage account. There’s a lot of neat stuff that we can do.

Steven Jarvis:     Yeah. And as we look at the different potential tax buckets, which is what we’re talking about here, essentially, is different types of accounts and how they’re taxed, it’s also nice to have flexibility.

But I think that’s a lot of what you’re speaking to, is as we get to different decision points in life or we’re looking at what we’re going to do with the legacy of our wealth. But having that tax flexibility is also advantageous as opposed to strictly focusing on what is the absolute dollar savings of particular tax strategy.

Because no matter how well we plan, unexpected things are going to come our way. And having a little bit of flexibility as far as where those funds come from or how we use them can be very advantageous.

Benjamin Brandt:         Yeah, flexibility is great. I just had a conversation with a client the other day and we were actually talking about his mom’s account and he wanted some advice on what mom should do. And he had some highly appreciated stock and then he also had a brokerage account, and in the brokerage account there were some losses.

And so, he had suggested, “I’ve got this stock that …” that actually his dad bought decades ago, “I think I’ll just cash this in and help pay for mom’s nursing home.” And we thought, well, we actually have this brokerage account over here. I think actually the tax implications would be less if we just sold some of this out of this brokerage account.

So, many instances clients have, let’s say they have a million dollars in an IRA, but 50,000 in a Roth IRA, doing Roth conversions over time, and they have a brokerage account. Well, something happens in life where they need an additional $20,000 from some investment.

Well, if we take it out of the IRA, that’s going to be income taxes, that’s going to impact how much Roth conversion we do at the end of the year, that’s going to impact their Medicare income-related amount.

The Roth IRA for many clients is like the golden goose. They don’t ever want to take money out of that because it’s just growing and it’s tax-free and it’s playing on the friendly side of the tax equation.

But they do need the 20,000. So, then we have that brokerage account where we can look at, is anything out of loss? What are some interesting things that we can do? So, that flexibility of that brokerage account can be a big asset in the right situations.

Steven Jarvis:     Yeah, absolutely. But going back to that order of operations, we want to go back and kind of step through this and say what makes the most sense.

Benjamin Brandt:         Yeah. I wouldn’t want you to put extra money in the brokerage account just for the balance factor. I would still want you to get the match. I still want you to get the Roth, if that’s appropriate. Don’t skip the line, go through the orders of operations.

Dave Ramsey would call them baby steps. Maybe we’ll think of a clever name for our order of operations.

Steven Jarvis:     Well, and really the other listener question we wanted to address kind of speaks to this as well.

The listener writes in and says, “Is it possible to have too much Roth money? I’m in my thirties and have contributed to a Roth IRA and Roth 401(k) during my twenties and into my thirties, and my only pretax money is my employer matching contributions.”

And so, really the question is, is there some disadvantage to having just, I think 90% of your savings in Roth is what this listener is at?

Benjamin Brandt:         Well, I want to give a special shout out to our youngest listener. This came from the listener survey and if you answered the listener survey, we asked you if you’re in your twenties, thirties, forties, fifties, sixties or above, and I think we had one or two people in their thirties.

And so, this would be that individual. So, thank you. Thank you for being our unofficial youngest listener.

Is there such a thing as too much in the Roth? I would say at your age, definitely not. When I was young and first starting out in my savings journey, I was sticking everything I could in the Roth, because I had an idea that I’m investing in myself through coaches and courses and mastermind groups.

And I thought my business is going to grow and my income’s going to go up. And at some point, in the near future, hopefully, knock on wood, my income is going to be such that I would rather have the deduction than the tax-free growth.

And so, you might be making that same bet on yourself, listener. So, I say now in your twenties and thirties, there’s no such thing as too much money in the Roth. Because if you’re listening to this podcast, you’re probably making investments in yourself. It’s only reasonable to assume in the future, you’ll be more successful financially. And you might be more in line where you’d want deduction rather than tax-free growth.

So, squirrel away as much money as you can in your twenties and thirties. It’s already tax-free because it’s in the Roth. If you’re earning 7% a year, you’re going to double every 10 years by the rule of 72.

So, maybe maxing out that Roth 401(k) in your twenties and thirties, maybe you don’t actually need to save anything in the Roth after the fact. Let’s say you start making really good money at 35 and now, you need the deduction, those Roth valves are still working for you behind the scenes and earning that fantastic tax rate cap on interest.

So, something to think about, but life might not always be that way, but you’ll be happy that you squirreled away this money, I think early on in your career. That’s my 2 cents anyway.

Steven Jarvis:     100% agree with that, Ben. If I could just pick one bucket to have all my money and I couldn’t use the other ones, I think Roth, that’s probably where I would start. There’s definitely some huge advantages there, and you really speak to a lot of the things that people should be thinking about.

I can’t think of any, especially from a tax law standpoint, I can’t think of any disadvantages. So, I’ve met just a handful of clients that have a hundred percent of their savings in Roth, beyond emergency fund. Usually, it’s not what people have done.

But thinking about especially those kind of peak earning years for a lot of people, they’re going to have some years of their career where they’re at their highest earning and at some point, their tax rate’s most likely going to go down.

And so, I still know people who at that point will say, “Nope, I would rather not let the IRS change the game on me later.” But they’re making an informed decision that they know that they might be paying more in taxes than if they were to defer.

But love how early that this listener’s getting started and how committed they are to investing.

Benjamin Brandt:         Absolutely. I’ll be 41 in a short while, in a couple days. And if I could wave a magic wand and take all of my 401(k) and IRA money and just make it in a Roth IRA, I would absolutely do that.

And you’re already there listener. So, yeah, I’m envious of your position, so keep it going as long as you can. When you decide that you do need that deduction, you can go ahead and flip the switch and put it in the regular 401(k). But all that Roth money will still be working for you behind the scenes, so keep it up. You’re doing fantastic and thanks for listening.

Steven Jarvis:     Yeah. And Ben and I will do our best to find that magic wand he talked about. Although I’m not really holding out a lot of hope. I’m going to stick to my proactive tax planning. If the magic wand comes along, then bonus.

Benjamin Brandt:         I think the magic wand is in the same drawer as the magic eight ball, which is broken, so-

Steven Jarvis:     Dang it. Well, Ben, as always, I really appreciate you sharing your insight and answering listener questions. This has been great.

Benjamin Brandt:         Yeah, thanks for tuning in. And until next time, don’t let the tax man hit you, where the good Lord split you.

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