Schwab Mega Backdoor Roth: The #1 Set-Up Guide

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Every business owner should consider a Schwab Mega Backdoor Roth. This of course assume that you use Schwab as the investment custodian for all your other investments.

What is a Schwab Mega Backdoor Roth?

A Mega Backdoor Roth is a strategy for contributing additional after-tax funds to a 401(k) plan, which can then be converted to a Roth IRA. This strategy can allow individuals to contribute significantly more money to their retirement savings than would be possible with traditional contribution limits.

To understand how a Mega Backdoor Roth works, it’s important to first understand the contribution limits for 401(k) plans. For 2023, the contribution limit for pre-tax 401(k) contributions is $19,500, and the limit for catch-up contributions for those over age 50 is $6,500. However, the total contribution limit for both pre-tax and after-tax contributions is much higher, up to $64,500 in 2023.

With a Mega Backdoor Roth, an individual can contribute after-tax dollars to their 401(k) plan, beyond the $19,500 limit for pre-tax contributions. Once these after-tax funds are in the 401(k) plan, they can be converted to a Roth IRA, which allows for tax-free growth and tax-free withdrawals in retirement, as long as certain conditions are met.

The Mega Backdoor Roth strategy can be particularly beneficial for high earners who are not eligible to make Roth IRA contributions due to income limitations. By contributing after-tax dollars to their 401(k) plan and then converting to a Roth IRA, they can still take advantage of the tax-free growth and withdrawals that a Roth IRA offers.

It’s important to note that not all 401(k) plans allow for after-tax contributions or in-service withdrawals, which may be necessary to convert the funds to a Roth IRA. Additionally, the conversion of after-tax 401(k) funds to a Roth IRA may trigger taxes on any earnings in the account, so it’s important to carefully consider the tax implications before using this strategy.

How do you set up a Mega Backdoor Roth?

Setting up a Mega Backdoor Roth involves several steps and requirements, and it’s important to understand the rules and limitations before proceeding. Here’s an overview of the steps involved:

  1. Check if your employer’s 401(k) plan allows after-tax contributions: Before you can do a Mega Backdoor Roth, your employer’s 401(k) plan must allow for after-tax contributions. Not all plans do, so you’ll need to check with your plan administrator to make sure this option is available.
  2. Max out your pre-tax 401(k) contributions: You must first make the maximum allowed pre-tax contributions to your 401(k) plan before you can contribute after-tax dollars. The maximum allowed contribution for 2023 is $19,500, and if you’re over 50, you can make an additional catch-up contribution of up to $6,500.
  3. Contribute after-tax dollars to your 401(k) plan: Once you have made the maximum allowed pre-tax contributions, you can start contributing after-tax dollars to your 401(k) plan. The maximum after-tax contribution limit for 2023 is $38,500, which includes the pre-tax contributions you’ve already made.
  4. Convert after-tax contributions to a Roth IRA: Once you have made after-tax contributions to your 401(k) plan, you can then convert those funds to a Roth IRA. This can be done either while you’re still employed or after you leave your job. It’s important to note that you’ll need to pay taxes on the earnings when you do the conversion, but the contributions themselves will not be taxed again.
  5. Pay attention to the pro-rata rule: If you have pre-existing funds in a traditional IRA, the “pro-rata rule” can complicate the process of doing a backdoor Roth conversion, and you should consult with a tax professional to determine how it may apply to your specific situation.

It’s important to note that Mega Backdoor Roth contributions can be complex and require careful planning and tracking of contributions and conversions. If you’re interested in doing this, it’s a good idea to work with a financial planner or tax professional to make sure you’re following the rules and taking advantage of the benefits.

What is the difference between a Roth 401k and a pre-tax 401k?

The main difference between a Roth 401k and a pre-tax 401k is the way contributions are taxed.

With a pre-tax 401k, contributions are deducted from your paycheck before taxes are taken out. This means that you lower your taxable income, which can result in a lower tax bill for the current year. However, when you withdraw the money in retirement, you will have to pay taxes on both your contributions and any earnings.

On the other hand, with a Roth 401k, contributions are made after taxes have been taken out of your paycheck. This means that you won’t get an immediate tax break, but when you withdraw the money in retirement, you won’t have to pay any taxes on the contributions or earnings, as long as you meet certain requirements.

Another difference between the two is the contribution limits. For 2023, the contribution limit for both pre-tax and Roth 401k is $19,500. However, individuals who are age 50 or older can make additional catch-up contributions of up to $6,500 in 2023 to both pre-tax and Roth 401k plans.

It’s important to note that employers may not offer both types of plans, and may only offer one or the other, so it’s important to check with your employer to see which options are available to you. Additionally, it’s important to consider your current and future tax situation when deciding between a pre-tax or Roth 401k.

Paul Sundin

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