529 to Roth IRA Conversions Under New Cares Act 2.0 Rules

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529 to Roth IRA Conversions Under New Cares Act 2.0 Rules

Under the Cares Act 2.0 passed in December, savings from 529 education savings accounts can now be rolled over to a Roth IRA (starting in 2024).

This is an important update for parents or grandparents saving for their children or grandchildren’s future. A major concern with 529 accounts has always been “what if my child/grandchild doesn’t end up going to college”? Previously this would have triggered income tax and a 10% penalty to distribute that unused money. Under these new rules, the balance could now be rolled over to a Roth IRA for the beneficiary of the 529 (in this example the child/grandchild).

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Inflation Is MUCH Lower Than You Think

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Inflation Is MUCH Lower Than You Think

The media and the average person misunderstand and misinterpret inflation for two important reasons:

  1. They focus on the ANNUAL reported inflation number which tells you what has happened over the past year but not where inflation is headed.

  2. The SHELTER component of inflation which measures rents and home prices makes up about one third of overall inflation but lags real-time housing data by up to 12 months.

The most recent inflation report that was published on 12/13/2022 makes an excellent illustration of these two points. Understanding the nuance of inflation reports and where we are headed rather than where we have been is key for setting expectations for how much further and how quickly the Fed will continue to raise interest rates as well as how long rates will remain elevated.

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Why Is Your Cash In The Bank?

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Why Is Your Cash In The Bank?

Typically, people keep money in the bank for three reasons: 1. Safety 2. Return (interest) 3. Accessibility. In the current environment, short-term bonds actually beat banks on two of those three criteria and aren’t far off on the third.

NET OUT - If you’re willing to hold a treasury bond until the end of it’s term, you know the minimum return you will receive, the only risk of loss is if the US government defaults on its debt, and your bond has the potential to do better than expected if interest rates drop.

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Mega-Backdoor Roths Aren't Just For "Rich" People

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Mega-Backdoor Roths Aren't Just For "Rich" People

There are many examples of situations where mega-backdoor roth contributions can be unexpectedly relevant but there are some overarching themes:

  • When the amount of money coming in during a year is significantly higher than usual

  • When your expenses are significantly lower than usual but your income hasn’t changed

  • When you’ve built up more savings than you need for your emergency fund and short-term goals

  • When one spouse has access to a 401k and the other working spouse does not

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2023 Contribution Limit and Tax Adjustments (mostly) Keep Up with Inflation

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2023 Contribution Limit and Tax Adjustments (mostly) Keep Up with Inflation

While the 2023 social security cost-of-living increase of 8.7% grabbed most of the headlines, the IRS also adjusted tax brackets and contribution limits for 2023 to keep pace with the 8.2% annual inflation rate reported in October. While many adjustments kept up (401k contribution limits increased 9.8%, IRA limits by 8.3%), the Feds were stingier with others (tax bracket thresholds increased only 7.1%, the standard family deduction by 6.9%, Roth income limit by 6.9%).

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Mega-Backdoor Roth - The Hidden 401k Feature that can Supercharge Your Retirement Saving

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Saying that the Mega-Backdoor Roth strategy can supercharge your retirement saving is not a hyperbole. In most situations, maximizing this feature MORE THAN DOUBLES the amount you can save to Roth accounts each year. Once those savings are invested in a Roth account, they can grow tax free for years or decades and be withdrawn tax free* in retirement.


The “mega-backdoor” can have mega tax impacts

A quick example illustrates just how powerful those tax savings can be:

Each year for 20 years, “normal 401k Charlie” maxes out his Roth 401k with $20,500 and invests an additional $40,500 in a taxable investment account. Both accounts grow at 6% per year. At the end of 20 years, Charlie has $1,497,169 in his taxable account and $757,826 in his 401k; $2,254,995 in total. While Charlie’s Roth 401k savings can be withdrawn tax free in retirement, he will owe capital gains tax on the $687,169 of his investment gains in the taxable account. At long term capital gains rate of 15% that would be $103,075 in taxes! This doesn’t even include taxes he would likely have paid on dividends in the taxable account over 20 years.

“Mega-backdoor Bettie” on the other hand maxes out her normal $20,500 Roth 401k contribution and is able to invest an additional $40,500 into her Roth 401k through the Mega-backdoor strategy. After 20 years, with the same investment return as Charlie, Bettie has the same total savings of $2,254,995. However, Bettie can withdraw that full amount tax free in retirement.

In this example the Mega-backdoor saved Bettie $103,075 on taxes! She also didn’t pay tax on any dividends along the way.


How to implement the Mega-Backdoor strategy

Hopefully this example helps illustrate that the Mega-Backdoor Roth can be a powerful tax-saving strategy, but how does it work? By making after-tax 401k contributions and in-plan Roth conversions. Let’s break those two steps down:

1) Allowing after tax 401k contributions increases the maximum amount employees can contribute from $20,500 in 2022 to $61,000* (or $67,500* if you’re over 50). After-tax contributions don’t reduce your taxable income or tax bill today, but this is where the in-plan Roth conversion is key.

2) Through an in-plan conversion you can easily take those huge after-tax contributions and convert them to Roth funds within your 401k (or through rollover conversions to a Roth IRA). Once converted, your savings grow tax-free and can be withdrawn tax free in retirement just like normal Roth 401k or Roth IRA contributions.

This is the power of the mega-backdoor, it allows you to quickly build a much bigger tax-free* retirement nest egg than you could with a typical 401k and Roth IRA alone. And, unlike a Roth IRA where households over the income limit aren’t allowed to contribute, anyone in the plan can contribute with no income cap. This means even high earning households can mega-backdoor. It’s actually this group that can benefit the most!

 

Some 401k plans don’t support the Mega Backdoor and some require an extra step

Unfortunately, many 401k plans don’t allow allow for employees to make after tax contributions. Sadly, there’s not even a good reason for this other than perhaps some added administrative difficulty. That said, it is becoming more and more common and will likely continue to grow in popularity. Some plans allow for after tax contributions but don’t have a program set up for in-plan conversions to Roth. This is where a second step is needed to see if the plan does allow for “in service distributions” so that employees can roll over their after tax contributions to an IRA and convert them to Roth. If you’re unsure what you’re plan allows or how to execute this step please reach out, I’m happy to help.

The Mega Backdoor isn’t right for everyone

Let’s be honest, making mega-backdoor Roth contributions isn’t realistic for a lot of people. Maxing out a $20,500 annual contribution is already a lot! In fact, it may already be more than enough for your situation and retirement goals. That said, there are a lot of unique situations where a mega backdoor strategy can become unexpectedly relevant, I’ve written about several of them here: Mega-Backdoor Roths Aren’t Just for Rich People.

Like any large money decision, mega-backdoor Roth contributions should be part of a bigger financial and tax strategy built around your needs, your timeline, and your goals. If you’d like help building a strategy tailored to your timeline and goals (or figuring out if your employer allows the mega-backdoor), feel free to reach out, I’d love to see if I can help or direct you to someone who can. You can reach me by email at ryan@ffadvisor.com or cel phone: 616.594.6205.

 
 

Footnotes:

*Roth savings grow tax-free. Contributions can be withdrawn without tax or penalty at any time and investment gains can be withdrawn tax and penalty-free after age 59-½ (or 55 if the “rule of 55” applies to you).

*$61,000 and $67,500 are the 2022 limits for employee contributions, employer matches, and profit sharing contributions combined. Your max contribution = $61,000 or $67,500 - employer match - profit sharing contribution.