If Roth accounts are so good that the government limits who contributes and how much they can contribute, then why do we have “loopholes” like the backdoor Roth and mega backdoor Roth that allow people to contribute when they shouldn’t be able to?
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When it comes to retirement savings, many people are familiar with traditional Roth IRAs and 401(k)s. However, there are also two lesser-known options known as the backdoor Roth and the mega backdoor Roth. These options have often been referred to as “loopholes” in the tax system, but why are they allowed?
The backdoor Roth IRA is a strategy that allows high-income individuals to contribute to a Roth IRA, even if their income exceeds the limits set by the IRS. This is done by making a non-deductible contribution to a traditional IRA and then converting it to a Roth IRA. The mega backdoor Roth, on the other hand, allows individuals to make after-tax contributions to their 401(k) plan and then convert those contributions to a Roth IRA.
So why are these strategies allowed, especially when they seem to go against the intended purpose of the tax rules? One reason is that the tax code is complex and often contains unintended consequences. When the rules for Roth IRAs and 401(k) plans were created, they were meant to provide a tax-advantaged way for individuals to save for retirement. However, the income limits set on Roth IRA contributions were intended to prevent high-income individuals from taking advantage of the tax benefits.
The backdoor Roth and mega backdoor Roth strategies were not explicitly prohibited in the tax code, which has allowed individuals to take advantage of them. Additionally, the IRS has not taken a strong stance against these strategies, which has further contributed to their widespread use.
Another reason why these strategies are allowed is that they provide a way for individuals to save more for retirement. High-income individuals who are unable to contribute to a Roth IRA or make after-tax contributions to their 401(k) plan due to income limits would otherwise be limited in their retirement savings options. By allowing these individuals to use the backdoor and mega backdoor Roth strategies, they are given the opportunity to save more for retirement and take advantage of the tax benefits that come with Roth accounts.
It’s worth noting that while these strategies are currently allowed, there is always the possibility that the IRS or Congress could take action to close these loopholes in the future. For now, however, the backdoor Roth and mega backdoor Roth strategies remain legitimate options for individuals looking to maximize their retirement savings.
In conclusion, the backdoor Roth and mega backdoor Roth strategies are allowed because they are not explicitly prohibited in the tax code, provide a way for high-income individuals to save more for retirement, and offer a way to navigate around the income limits set for Roth IRA and 401(k) contributions. While they may seem like loopholes, they are currently legitimate options for individuals looking to take advantage of the tax benefits of Roth accounts.
Technically, it's not called an in-plan "conversion": it's an in-plan rollover according to the IRS § 402A(c)(4). Even the taxable gains from the after tax contributions are considered an in-plan rollover even though it is being converted from pre-tax to after tax if the plan allows it. If you rollover after tax from 401k to Roth IRA, you have to proportionally rollover or take a distribution on any gains from the after tax contributions. You can directly roll over the earnings, which are pre-tax, into a Traditional IRA, then backdoor convert to a Roth IRA…whether that is tax efficient will depend on the structure/nature of any existing traditional ira balances.
They knew this would be a thing that could happen, and they intentionally pushed it through because the budget oversight committee is only allowed to examine the effect on tax revenue 10 years into the future.
They knew from the moment that it was created that this would be a thing, and they used it as a false offset (claiming it would actually increase tax revenue) to keep the capital gains tax rate low.
I didn't understand a word of this. Hope my pension stays solvent.
I have a rollover IRA from an old 401k (before i knew about backdoor Roth), so I know that I should not attempt to do a backdoor Roth using this account. But how do I fix this situation? Can I create a new IRA account with another bank to use for backdoor purposes?
They failed to explain this scenario. I had this exact thing happen to me when I initially changed from 100% traditional 401k contribution to Roth 401k. What I didnt realize was that I was actually putting money into After-Tax 401k (If thats the correct terminology). I had that fixed after a few months so I asked my company's 401k administrator (Empower) whether I can transfer the after-tax 401k to Roth 401k (In-service distribution?) and they told me no. The excuse was that my after-tax had already grown to $10,000 with after-tax and pre-tax gains mixed in and was advised not to touch it. Why even bother with after-tax 401k when you have to pay ordinary income tax when you withdraw sine Roth exist. I am not satisfied with their answer. Also does this mean that I can contribute over the $22,500 max limit with after-tax 401k? Whats the difference between a brokerage with long term capital gains or qualified dividend payouts since those have lower tax brackets to begin with?
Clearly nobody has an issue with you putting too much money in ROTH as there are now 401k's that are ROTH that allow you to, regardless of your income, contribute to ROTH and do so at the full annual 401k limit into them rather than just the $6500. It strikes me that the arcane ROTH rules are simply a useless piece of antiquated legal code that nobody has yet bothered to do away with. It's sorta like it being illegal to catch fish with your bare hands in Pennsylvania.
Yes, because Dave Ramsey does it and he wouldn’t do anything immoral and promote ppl to do it.
We have a high income (~$500K), and my wife and I both have maxed 401(k)s. Our advisor told us that we were ineligible for the tax benefits of an IRA, so we'd end up paying significantly more tax by doing a backdoor Roth. I think it was because my wife has an existing IRA. I can't remember the specifics.
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