I happened to meet with our financial advisor the day after I read the article about how older folks are leaving the workforce because they are stock-rich. I told him about the article. He just laughed & said sometimes when you assume …
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I find articles by Investopedia quite helpful. Here is one, but I’m sure you can Google and find others on the same platform.
https://www.investopedia.com/terms/b/backdoor-roth-ira.asp
The topic confused me when I first heard about it also because there’s the back door Roth and the mega back door Roth. The back door Roth is performed by an individual, whereas the mega backdoor Roth is offered by a company.
Once a single tax filer earns approximately $150,000, he is no longer eligible to contribute directly to a Roth IRA. He can make a non-deductible contribution to an IRA, and then convert it to a Roth IRA. While earning less than $150,000, he was able to contribute to directly to a Roth IRA. One important caveat here is to ensure that he does not have any money in an IRA already. For a young person, this might have happened if he rolled over an old employer 401(k) to his own IRA. If that did happen, he should ask if his new employer will allow him to roll his old IRA into his new companies 401(k).
I’m not going to speak to mega back door Roth, because my children do not have access to them so I do not understand the mechanics.
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I am not sure if this is what you were asking, but assuming he earns under $150,000, he can contribute $7500 to a Roth IRA (an account that he controls completely at Fidelity or Schwab or wherever), and then he can also contribute up to $24,500 to his company plan. He should be allowed to allocate the $24,500 between the traditional 401(k) and the Roth 401(k). I don’t know his company would have any rules or restrictions about this, but I am guessing he should be able to change his allocation throughout the year, and he can definitely change his allocation from year to year.
What I have been supporting is fully funding the Roth 401(k) up to the top of the 24% federal bracket. I realize that there’s another 9.3% to pay in California, so it’s definitely a risk. But if you have a young person earning $150,000+ a few years out of school, you have to imagine his pay will go up from there, and his tax bracket may never be this low again.
If he is already earning above the 24% bracket (almost $220K before std deduction), that would land him at 32% federal + 9.3% California, so I think it would be time to go all traditional 401(k).
As to his not wanting to lose the tax deduction of the 401(k), that is a valid point, but once you look at the next 40 years of earnings that will most likely be at a higher tax bracket, this might be the only time to fund a Roth 401(k).
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He does have a Roth IRA he’s been contributing $7500 to (or whatever it was each year) so does that prohibit him from doing a backdoor Roth?
No, not at all. If his income remains below 150,000 (or whatever the cutoff is this year–it goes up a little each year), he can contribute directly to his Roth IRA. Once his income exceeds that limit, he would have to perform the back door Roth which requires first contributing to a non-deductible IRA, and then converting it to Roth.
But he can’t do that if he has an existing IRA balance. No problem if he has an existing Roth IRA balance.
Mega back door Roth does offer the benefit of tax-free growth. It allows for funding a Roth in excess of the usual annual limits. My limited reading on the topic suggests that many plans cannot pass discrimination testing.
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Thank you - he is in the 24% but just spent some time with ChatGPT and wow, what detail. I do understand the backdoor Roth now, was not understand the pre-tax/post-tax Roth IRA as I had mistakenly assumed they were all post tax. Anyway, learned Calif is not HSA tax friendly, but still worth it for the federal deduction.
What does discrimination testing mean? I don’t follow.
I should try using AI, but still just google. I realize I am making things more difficult for myself!
Yes, HSA in CA requires an additional step at tax filing time. In addition to contributions not being deductible, account earnings are subject to CA income tax, so he will have to manually track and report the HSA earnings at tax filing time.
Wait–what do you mean about pre and post tax Roth IRA? All Roth contributions are post-tax.
RE: Discrimination testing–just google that as I don’t have a full handle w/o doing so myself. There are rules about amounts/percentages that can be contributed by highly compensated vs lower comp, and mega backdoor Roths have trouble passing this test for obvious reasons.
This is not something your son needs to worry about. Handled at the company level.
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I meant when referring to IRA (not Roth) because my mind just thought all IRAs were after taxes, I know better, just getting myself confused and the more I learn, the more confused.
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I have always wanted to do a Roth conversion. But I have had two related first world problems. I will be at a high rate before and after RMDs kick in. I thought it would not make sense to do conversions, but recently thinking about MA estate tax might change things. Given that my estate would have to pay MA estate tax on whatever is left over in the 401k (in addition to ordinary income tax at the time), would it be better to convert now to a Roth and pay the ordinary income tax sooner but avoid the estate tax?
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I have seen this idea mentioned previously. If you can reduce the total money remaining in your estate by paying the taxes on a conversion upfront, you will owe less in estate taxes, but will pay quite a bit in Fed, MA & IRMAA in order to do the conversion.
A number of factors to model. Off the top of my head –
What will your total tax rate be when converting to Roth, including IRMAA impacts, and the 4% MA surcharge on incomes above a million-ish.
What estate tax rate your will your estate pay if you do not convert vs if you do convert?
What income rate will your beneficiaries pay when taking the Inherited IRA RMD’s over ten years?
Complete unknown, but how many years will the surviving spouse be paying the single tax rate?
I do not know the answer to this, but how does Massachusetts tax gifts from your estate prior to death?
I hope I have not served confuse you further!
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No, it’s not YOU, it’s ME!
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Too many unknowns for us to opine. (no need to post your details)
But as to the theory, yes, it is recommended for folks that may be near a cliff, particularly the fed’s $15m (Single). Convert today to avoid a 40% estate tax on amounts over $15m (plus inflation).
Same holds true for those with a state estate or inheritance tax. Generally, state taxes are a whole lot less than 40%. However, I see that Mass is 16% for 8-figure estates.
Nevertheless, its still a tax arb: your marginal fed/state tax rate today vs heir’s tax rate when you die PLUS any state estate/inheritance tax.
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Delete
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I think you should gift over the years - maybe that’s what $19k is. So no tax.
I mean you can run 95k over 20 years at x rate (like 5%) and see what it would be worth. But he’d have it and if he invested it, it may be the same, more or less, depending on how it performed with him.
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Yes, that’s the idea – to let him manage the money and make decisions about it rather than it sitting with us. But at the end of my life, assuming all goes as it should, there will still be a big pot of money to split between the two kids and just halving it no longer feels equitable as Kid One got money front-loaded.
The gift would also come with a one-time mtg with a FA. Kid Two already has an ongoing relationship with a FA.
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Can you just give both the same amount for the 5 years? Seems the most likely to be fair.
Or, what % of your net worth is the present value of that money, and adjust the distribution percentages by that %?
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This is kind of making my head hurt. Could you create a separate account somehow earmarked for the second child, fund that account with the same $19,000 a year that you are distributing to the first child? I am guessing that you could name child two as the sole beneficiary of this account.
Questions about your tax rate today versus what child two’s tax rate would be if he had the money today? I believe the account would step up in basis upon your death, so that could be tax advantageous for child two.
Do you have any estate or inheritance taxes to consider?
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