Need to Roll Over a 401(k)? Try This Tactic to Save on Tax Payments

Are you planning to switch jobs? Or have you inherited a 401(k) plan from your previous employer? If so, then you might be considering a rollover to maximize your retirement savings. However, rolling over a 401(k) plan can lead to sizable tax payments, especially if you withdraw the funds before age 59½ and you don't roll over the funds into another qualified plan.

But what if I tell you there's a way to avoid or significantly reduce your tax payments? Yes, it is possible -- through a mega backdoor Roth IRA.

What is a mega backdoor Roth IRA?

A mega backdoor Roth IRA is a strategy that allows you to contribute after-tax dollars to your employer's retirement plan and then roll over the funds into a Roth IRA account. With a mega backdoor Roth IRA, you can save an additional $43,500 per year (as of 2023), which is well above the standard Roth IRA contribution of $6,500 per year. This technique can help you save a significant amount of tax-free money for your retirement, especially if you have a high income.

One important thing to note about a mega backdoor Roth IRA is that it is only available to individuals who have access to a 401(k) plan that allows for after-tax contributions. This is because a mega backdoor Roth IRA requires you to contribute money to your 401(k) plan beyond the traditional pre-tax limit. If you don't have access to such a retirement plan, this strategy won't be available to you.

How to execute a mega backdoor Roth IRA

To take advantage of a mega backdoor Roth IRA, you need to follow a few steps. First, you need to maximize your traditional 401(k) contribution limit, which is $22,500 in 2023. Next, you need to contribute additional funds to your 401(k) plan beyond the pre-tax limit, up to the annual after-tax contribution limit, which is $66,000.

Finally, you need to convert the after-tax contributions to a Roth IRA. This conversion process is what makes your contribution tax-free. You will also need a 401(k) plan that allows in-service withdrawals. These withdrawals are vital for the mega backdoor Roth IRA process: You contribute after-tax income, then promptly make an in-service withdrawal before the contributions generate taxable returns during a rollover.

If your retirement plan does not permit in-service withdrawals, you can still perform a mega backdoor Roth IRA after leaving your current job, but you will likely be subject to taxes on any investment earnings during the rollover.

Pros and cons of a mega backdoor Roth IRA

The strategy allows you to contribute a significant amount of after-tax dollars to your retirement plan -- up to $43,500 in 2023. There are several major benefits of a Roth IRA, such as tax-free growth and qualified withdrawals that are tax-free. The Roth has an income limit though, so a mega backdoor Roth IRA allows high-income earners to take advantage of a Roth.

However, the strategy's effectiveness depends on your income level. It might not be suitable for people with lower incomes. You will have to max out your 401(k) and then still have enough disposable income to take full advantage of this strategy. In addition, not all employers offer a 401(k) plan, and if they do, they will need to allow after-tax contributions and in-service withdrawal. Lastly, the strategy is complicated, requiring compliance with IRS rules and possible tax consequences.

A mega backdoor Roth IRA is a powerful strategy that enables you to contribute more after-tax dollars to your retirement account, thus growing your nest egg and reducing your tax burden. But it requires careful planning, compliance with IRS regulations, and the right income level. If you're eligible, consult with a professional to assess the strategy's effectiveness and suitability for your retirement goals. Ultimately, a mega backdoor Roth IRA can help diversify your retirement portfolio and provide tax-free retirement income in the long term.