As we head into the year’s final quarter, many people will reflect on 2024 to make resolutions for the new year. Instead of waiting until December to reflect, now is a good time to take stock of your retirement game plan.

Some popular strategies might be familiar to you, and you might be using them already. Because of their potential for tax-free income in retirement, after-tax Roth IRA contributions inside a retirement plan and to a Roth IRA are attractive retirement savings strategies.

But did you know there are additional strategies that could help you maximize tax-free income in retirement?

Enter the backdoor Roth IRA and mega backdoor Roth IRA options: powerful savings strategies that might offer significant benefits.

Backdoor Roth IRA

A backdoor Roth is a savings strategy that allows high-income earners to contribute indirectly (through the “backdoor”) to a Roth, even if their income level exceeds the IRS limit for Roth contributions. Yes, you read that correctly … high-income earners CAN contribute to the Roth source within their 401(k) and indirectly to a Roth IRA.

To make contributions to a Roth in 2024, a single tax filer must have a modified adjusted gross income of less than $161,000, and a married couple filing jointly must have a modified adjusted gross income of less than $240,000. Note that the IRS may adjust these income limits for 2025.

A backdoor Roth is an option when individuals:

• Contribute deductible (pre-tax) contributions to a traditional IRA and convert the funds to a Roth
• Contribute nondeductible (after-tax) contributions to a traditional IRA and convert the funds to a Roth

When assets transfer from a traditional IRA to a Roth, you must pay taxes on any deductible (pre-tax) contributions and any earnings that have not been taxed at the time of conversion. Once converted, the principal and earnings can grow tax-free, provided you follow the IRS rules for a qualified withdrawal.

Mega Backdoor Roth IRA

Mega backdoor Roth is a savings strategy that occurs inside a 401(k) plan and has the potential to allow individual contribution amounts significantly higher than the Section 402(g) limit, also called the employee contribution limit. The 2024 employee contribution limit is $23,000 for those under age 50 and $30,500 for those age 50 and older.

By making mega backdoor Roth contributions, individuals can potentially defer up to the IRC Section 415 limit, also called the annual contributions limit.

The total annual contributions limit of $69,000 for those under age 50, and $76,500 for those age 50 or older, in 2024 includes ALL contributions to a retirement plan. These include individual pre-tax contributions, individual after-tax contributions, employer matching as well as employer nonmatching contributions.

(Note that it’s important to coordinate any voluntary after-tax contributions, defined in the next section, with all other employee and employer retirement plan contributions for the year to avoid exceeding the total annual contributions limit.)

Steps to Implementing a Mega Backdoor Roth Maneuver:

1. Maximize your pre-tax and Roth contributions inside your 401(k) plan.
2. Make voluntary after-tax contributions inside your retirement plan. Voluntary after-tax contributions are different from Roth deferrals. They are an “old-school” type of after-tax contribution in which the earnings do not grow tax-free. Participants may be able to make voluntary after-tax contributions up to the total annual contributions limit rather than the employee contribution limit.
3. Convert your voluntary after-tax contributions to Roth contributions via an in-plan Roth conversion.
4. A 1099-R will indicate taxes owed on any earnings generated from the voluntary after-tax contributions converted to Roth.
5. Your contributions plus earnings converted to Roth will grow tax-free, provided you follow the IRS rules for a qualified withdrawal.

For the maneuver to succeed, your retirement plan must pass required testing, allow voluntary after-tax contributions, and allow in-plan Roth conversions.

Because the plan must pass nondiscrimination testing, including all after-tax contributions, the maneuver works in limited circumstances:

• Solo plans, also known as “owner only plans” and “owner and spouse only plans,” are ideal candidates because the owners are the sole participants. Thus, the plan automatically satisfies nondiscrimination testing requirements.
• Plans consisting solely of Highly Compensated Employees (HCEs), as defined by the IRS, are also ideal. These plans automatically meet nondiscrimination testing requirements. For 2024, HCEs include individuals who own more than 5% of the company and employees who earned more than $150,000 in 2023. The compensation threshold increases to $155,000 for earnings in 2024.
• It’s unlikely the maneuver will work in a retirement plan consisting of both HCEs and Non-Highly Compensated Employees (NHCEs), as defined by the IRS, as these plans will likely fail required nondiscrimination testing.

Additional Considerations

Roth contributions and conversions are taxable in the year they are contributed or converted. Converting any amount of pre-tax contributions and could increase your taxable income, which may result in a higher tax bracket.

Additionally, the IRS imposes two rules to consider. The first is the pro-rata rule, which impacts the taxation of conversions, and the second is the five-year rule, which affects the timing of tax-free withdrawals.

The pro-rata rule prevents individuals from selectively converting, or “cherry picking,” only after-tax amounts to Roth.

Suppose your IRAs include pre-tax and after-tax contributions and you elect to convert only part of your contributions to Roth. In that case, the taxable amount will be proportional to the ratio of your pre-tax and after-tax balances in ALL of your IRAs combined. However, within a 401(k) plan, the pro-rata rule generally doesn’t apply, though this depends on the plan’s specific terms.

The five-year rule requires any withdrawal of funds from Roth conversions to meet a five-year waiting period to avoid penalties. Each conversion is generally subject to a separate five-year waiting period. Inside a retirement plan, the five-year waiting period begins the year you first make Roth contributions or a Roth conversion occurs, whichever happens first.

From time to time, Congress considers changes in legislation that could alter or eliminate backdoor and mega backdoor Roth savings strategies. For now, both strategies remain permissible by the IRS.

Due to their complexities, these backdoor Roth strategies require careful planning and execution. Working with a financial or tax advisor like those at TCO is crucial to avoid unintended tax consequences.

If you are a high-income earner and wish to maximize your retirement plan savings, these strategies could allow you to make significant Roth savings. Make the most of the year and talk with a TCO advisor today.