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Speaker 1: Today we’re breaking down exactly how to set up a backdoor Roth and a mega backdoor Roth step by step, the mistakes to avoid, and how this strategy can accelerate your path to financial independence. Let’s get into it. Hello, hello, hello, and welcome to the BiggerPockets Money Podcast. My name is Mindy Jensen, and with me as always is my has-a-Roth-IRA co-host, Scott Trench.
Speaker 2: Mindy, that was a great step one for introducing this podcast. For step two, I’m going to lead us into a conversion into the actual content of today’s show. We are super excited to be talking about this topic today and are bringing on two experts and familiar faces, Amanda Han and Matt MacFarland, to help us discuss how you can be doing the backdoor Roth contribution and the mega backdoor Roth contribution the right way. So Amanda and Matt, welcome to the BiggerPockets Money Podcast. Welcome back. Can we jump into it and you tell us what exactly a backdoor Roth is and who it’s for?
Speaker 3: Yeah, well, thanks for having us, guys. It’s good to be back. It’s always good to talk to you guys. Yeah, I mean, mega backdoor, backdoor Roth, it’s a great strategy for those high-income earners out there who are making too much money to directly contribute to a Roth, right? The IRS likes to put in there— Congress likes to put in rules that say, hey, if you make too much money, you can’t contribute to a Roth. But this is kind of that— we’ll call it that workaround. It lets you still get money into a tax-free environment for your future wealth building.
Speaker 2: And what are those limits?
Speaker 4: The IRS does not like to make things easy for us, right? So they put limitations around who can actually contribute. What are the income limits?
Speaker 3: Yeah, so for 2026, limits are still coming out, but for 2025, single person, if you made over $165,000, you were kind of capped at not being able to contribute directly to a Roth. And then for a married couple, if you made over $246,000, your ability to contribute to a Roth was limited. So that’s the people that are looking at potentially utilizing the backdoor Roth for sure.
Speaker 2: And just to preview this, the backdoor Roth and the mega backdoor Roth are kind of, in my opinion, very silly loopholes. Like it’s a very mechanical, very easy exercise if your employer allows it in the mega backdoor. And anybody can do the backdoor Roth. It’s kind of like, why do we have this limit if you can get around it this easily? Is that how you guys perceive it?
Speaker 4: Yeah, that’s what I was saying earlier. You know, the IRS doesn’t make things easy on us. They basically make us go through a hoop to kind of arrive at the same place. So the standard rule is, if your income is above those limits, then you are not able to put money into a Roth account. Why do we want money in a Roth? Because we want to grow tax-free, right? So they’re saying, hey, you made too much money, you don’t get this tax benefit. But the reason we call it a backdoor Roth is instead of just putting money directly in the Roth, you can take a two-step process to basically end up at the same place, which is money inside a Roth account. And the two-step process is, one, make after-tax contributions into a retirement account, let’s say an IRA. And then step two, take that money that you just contributed and convert it into the Roth bucket. So again, we kind of end up at the same place, but if you’re a high-income earner, then now you have to take two steps to get money in the Roth instead of the traditional direct contribution to the Roth.
Speaker 2: And this mechanically is as easy as literally creating a Schwab or Fidelity account, or insert your favorite brokerage of choice, setting up a traditional IRA, which has really very limited benefits for you, right? Traditional— like, it’s after-tax contributions. It doesn’t grow with any particular tax advantages in there. It’s just called a traditional IRA. And then you roll that over to a Roth IRA, right, within that same brokerage. And that’s the mechanical conversion for this. And that intermediate step is kind of silly and pointless. Is that the right way to think about it?
Speaker 3: For sure. And it’s one of those weird things that every year when we hear talk about what are the tax changes that are being milled over in Congress, you always think this is going to be put on the table, because how could it just keep going? Like, to your point, Scott, right, how does this quote-unquote loophole just keep existing, allowing people to kind of do this workaround? But you’re exactly right, it’s as simple as that. I mean, a typical scenario might be someone who’s always in this situation, they know they’re going to be making over that income limit every year. January 1st, they contribute their, you know, $7,000 to a traditional IRA, hit a button, five seconds later it’s converted to a Roth IRA, and lo and behold, we’ve done the same thing, right?
Speaker 2: So what are the contribution limits for backdoor Roths?
Speaker 3: In 2026, the annual contribution limit is up to $7,500. If you’re over the age of 50, you can contribute up to $8,600. That’s true to a traditional or Roth IRA, but obviously if somebody is prevented from contributing to a Roth directly, you can do that again through the backdoor Roth IRA.
Speaker 2: And this is per person, so a married couple can do that twice.
Speaker 4: Yeah, so each person as a married couple can do it. Generally, when you contribute to a retirement account, you have to have earned income.
Speaker 1: Right.
Speaker 4: But also, if you’re a stay-at-home spouse and your spouse has earned income, you can also do a spousal IRA as well. So both people don’t have to have earned income in that scenario.
Speaker 1: So can you do a spousal backdoor Roth if the working spouse is making more than the contribution limits?
Speaker 3: Yeah, absolutely. So, yeah, if your working spouse is making $150,000, in our example, each spouse could do it and put a non-deductible contribution into a traditional IRA and then immediately convert it to a Roth, effectively doing the backdoor.
Speaker 1: Okay, and just for my clarity, because I’ve never done a backdoor Roth before, if I put the money, the after-tax money, into the traditional IRA bucket and then convert, that conversion is not a taxable event because I already paid the taxes on that money, correct?
Speaker 3: Yeah, there’s some nuances there, but I’m sure we’ll get into it, right? But that is the general— if you’ve got nothing else in your traditional IRA, let’s say you just created the traditional IRA because you just heard about this, you put that $7,500 in there. When you convert it the next second, the next day, and it’s still worth $7,500, you’re not paying any tax on that conversion.
Speaker 2: Mechanically, this process takes minutes, right, with a major brokerage to set up. You literally create an account in Schwab or Fidelity, you create a traditional IRA, and then you convert it into a Roth. And that may take minutes of your time cumulatively. It may take a day or two to get approved through the brokerage for each of those moves. Is that correct, in essence?
Speaker 3: Yeah, absolutely. It’s a very simple process to go through. Again, we’ve got clients that do this January 1st every year because they know they’re not going to be able to contribute directly to a Roth, but they want to get that money into the Roth earlier in the year to start investing and get that tax-free wealth building right away.
Speaker 2: Okay, so now let’s talk about some of the mistakes you can make with this process.
Speaker 3: One of the big kind of nuances and mistakes to keep an eye out for is— for those people, this works really well again if you have no money in a traditional IRA already. Now, if you have money in a traditional IRA, there’s this thing called the pro rata rule, which just means that if you were to convert to a Roth IRA, some of it may be taxable, some of it may not, depending on if you’ve made non-deductible contributions before. So let’s say you’ve put in $20,000 of non-deductible contributions over the years, but the account has grown to $50,000, and you were to convert. So basically, 40% in our example is what we call basis, 60% is growth. Any dollar you convert at that point in time, 40% of it’s going to be non-taxable, 60% is going to be taxable. So that’s the pro rata rule that you have to keep an eye out for. Again, if all you have is non-deductible contributions— somebody who just created an IRA— this works really well. So it’s something that people need to keep an eye out for, for sure.
Speaker 4: And there’s another pro rata rule as well, where, you know, if I have $7,000 in my pre-tax IRA, it could be in a totally different account, and then I now put another $7,000 into my IRA to try to do the backdoor Roth, you might think, well, I just put in $7,000, I converted, it’s all going to be tax-free. But the tax law requires us to look collectively at all of your IRA accounts. In my example, then your conversion is deemed to have been half of it coming from the pre-tax, half of it coming from the post-tax. So you may end up paying taxes on half of that conversion, even though you didn’t write off the most recent contribution. So it’s another one to kind of look out for.
Speaker 1: Is there any way around that? Like, can you just take any existing traditional IRA money out and transfer it to a 401(k) or something?
Speaker 4: Exactly. Yep, you already gave away the answer. So that’s the strategy: how can I then move all of my pre-tax money out of the IRA, SEP IRA, right, all the different types, self-directed IRA, move them out into a qualified plan, like a 401(k) or a Solo 401(k). After you do that, then, if all I have is the after-tax IRA, when I convert, I generally don’t pay taxes on the conversion.
Speaker 3: So in that example I gave, right, if you had $20,000 of non-deductible contribution basis, and you had $30,000, you can move that $30,000 of growth. You could basically cherry-pick that from your IRA, move it into your qualified plan, the 401(k), leaving you with just basis in your IRA. So when you do the conversion of the $20,000 to the Roth, that $20,000 is completely tax-free. So that is definitely an awesome workaround in terms of that pro rata rule.
Speaker 1: Okay, and that’s not a taxable event, to use your example, to take that $30,000 of growth in my pre-tax IRA and move it to my pre-tax 401(k)? That’s just a sideways move. So then I’ve got the $7,000 new that I just contributed— or $7,500, because it’s 2026— and the $20,000 basis from before. Can I transfer all of that into a backdoor Roth, or all of that into a Roth account at one time?
Speaker 3: Yep. Simple. Again, simple mechanics, right? You’ve got a Fidelity account, you hit the button, and within a couple minutes it’s done. A couple days, it’s approved, and you’re off and running.
Speaker 1: Is there any limit to the amount you can convert into a Roth?
Speaker 4: No, it just— the general rule is you can convert any amount from one type of account to another type of account. There’s no limitations every year on conversion. The limitations we always talk about are always with respect to contributions— what is my maximum annual contribution.
Speaker 3: And that’s a great conversation for someone to have with their tax advisor or their team of advisors: how much should I convert this year? Where am I going to be? And is it going to be— do I need to worry about the pro rata rule? Do I have the ability to kind of work around that or not? And if I don’t, then what are my tax consequences? Let’s try and strategize around that, right? So you could convert all of it, you can convert some of it, you can cherry-pick over five years, one of those things.
Speaker 1: Yeah, and I think that’s a great time to remind everybody listening that Amanda and Matt are CPAs, but they are not your CPAs. So you should absolutely talk to your CPA about what specifically affects— let’s take a quick moment here.
Speaker 2: There’s no reason to do what we just went down. This entire rabbit hole is kind of a bad practice, right? You should not be overcontributing to this IRA that is neither a traditional pre-tax IRA nor a Roth. So you shouldn’t have a gain inside of the IRA to exclude from taxes in the first place. Best practice is just converting the amount you’re going to roll over into the Roth— just contributing that into the traditional, not investing it, and rolling it over immediately into the Roth on the 1st of January if you want to be lights-out perfect and get the maximum amount of growth. Is that correct?
Speaker 4: Yeah, best practice is just to do the backdoor conversion immediately, right? Easiest way to get rid of that pro rata rule. The other pro rata rule, where I just happen to have other pre-tax money— that’s the one we see more frequently. You know, had an old job, rolled it to an IRA, right? Rolled my 401(k) over. Now I got to worry about pro rata unless I move it to my new job’s 401(k).
Speaker 3: It’s funny, there’s a lot of tax returns that we have where a client will be— you look at the return, it’s like they took out $14,002 of IRA distributions, and $2 is taxable, because they left it in there for three days instead of five minutes, you know.
Speaker 1: So, Scott, I think it happens more frequently than you think. I think not everybody thinks like you.
Speaker 4: The other thing I would just add to is, when we review tax returns, one thing we see pretty frequently is people not reporting the cumulative basis in their Roth. So a lot of people will report the annual contribution and conversion for the backdoor, but not really keeping track of the cumulative basis in that account. So that’s always— for best practice, we always recommend that people include that on their tax return.
Speaker 2: From a best practices standpoint, to kind of summarize some of these— first, don’t leave money in the traditional IRA, do the rollover immediately. Otherwise, you’re going to complicate your life for basically no benefit over what you’d have if you just got that gain in your after-tax brokerage account. Second, don’t leave your money uninvested in some of these IRAs, don’t forget about it, which is kind of the same concept here. And then third, you’ve talked about these tax surprises— what are some things that we should worry about from a tax surprise perspective?
Speaker 4: Well, I think I would say, to the first step, before you do a backdoor Roth, talk to your CPA, review your accounts to make sure that you have moved out all of your pre-tax money right into the 401(k). So that would be step one, because that— I feel like that’s the part that surprises people the most. They hear, wow, that’s great, backdoor Roth, put in the money, convert it tomorrow. But later on, at tax return time, they find out, gosh, I have to pay taxes on some of that conversion.
Speaker 3: I think another mistake, just in general Roth conversions— and this rule changed a few years back— but when you did a conversion, you used to be able to undo it before you filed your tax return later in the year. So we can’t do that anymore. So if somebody finds themselves in a situation where they’re doing a conversion and maybe paying taxes on the conversion, because if they didn’t follow those steps and left some money in that traditional IRA, they want to be pretty certain of what their tax situation is going to be, because you can’t hit that undo button anymore. So sometimes in a situation like that, it might be a typical thing, like in Q3 or Q4, where someone’s like, hey, I’ve had a lower-than-usual income year, I’m looking at doing a Roth conversion, pay some tax on it. I just want to understand what my tax bracket is going to be, because you don’t want that surprise where I think I’m going to be in the 12% bracket and now I’m in a 32% bracket and can’t undo it.
Speaker 2: I think, just for those listening, this can be very confusing. And so I think we have to reset again on the basics here. There’s the pre-tax retirement account, like a traditional 401(k), and there’s an account that grows post-tax, tax-free, called the Roth IRA. Right. And then there’s various components of this— if you’re in the military, you’re in public sectors. And then in between, there’s this worthless account— I’m going to call it the worthless account— the traditional IRA that is neither pre-tax nor post-tax. Its only function that I can tell, for the purposes we’re talking about today, is to put money into it for a moment in time to then convert it into a Roth. The problem with this complexity here is that the Roth conversion, as most people in the personal finance space that are reasonably adept, will think of it, is really for the pre-tax, like the traditional 401(k) conversion over to a Roth, which is another advanced strategy that is using the same terminology but completely separate from what we’re talking about with the backdoor Roth. And that’s the thing that I think confuses people here. The backdoor Roth is literally using this worthless account, putting the limit into it, moving it over, and hopefully not having a gain that complicates your tax return inside of that.
Speaker 4: You know, there’s actually a name for what you’re describing. The worthless account is called an after-tax IRA. Its only benefit is tax-deferred growth, right, for that short amount of time.
Speaker 1: So just do it on Saturday, when the markets are closed and nothing’s growing.
Speaker 4: I do think that really the most people who fall victim to that worthless account, it’s just lack of knowledge, or they forget about it, right? I did the first step, I didn’t do the second step. That will kind of be the only reason why that would even come up.
Speaker 2: It’s not even a big deal. Like, you put it in there, it grows a little bit, you get taxed a little, move on. But it’s just like, why not? If you’re going to do the Roth conversion, the point is, move it quickly.
Speaker 1: And is there any time that this doesn’t make sense to do?
Speaker 4: It’s when you don’t want money in a Roth or a retirement account at all, right? Maybe you need the cash to live off of or to buy your home or to invest in different assets or real estate that may not be ideal inside of a retirement account. One of the questions we get a lot right after we talk to clients about Roth, the follow-up question most commonly heard is, “Great. When can I access that money? When can I pull it out?” So for us, it’s always really important to remind people that the purpose of having Roth money is not to pull it out. It is to leave it in there and let it grow exponentially for as long as possible on a tax-free basis. So who is it not ideal for? It’s not ideal for people who actually need the money right now.
Speaker 1: Let’s move on to the mega backdoor Roth. What is the difference between a mega backdoor Roth and a backdoor Roth?
Speaker 3: Main and huge difference between the mega backdoor and the regular backdoor Roth is that the backdoor Roth has to do with an individual retirement account. The mega backdoor Roth has to do with kind of that Roth bucket inside your qualified plan. So think of like a 401(k) at work where you’ve got a pre-tax bucket in there, maybe there’s an after-tax bucket, and then we’ve got this tax-free bucket, the Roth bucket. So I’m going to date myself, 10, 15 years ago these things didn’t exist, right? It was just—the 401(k) was a pre-tax account, but they’ve created these different buckets now that you can grow tax-free money inside a 401(k). And there’s basically something similar where you can kind of move that after-tax money you put into the 401(k) into the tax-free bucket because different limitations and things. But it’s pretty cool.
Speaker 4: Yeah, the way it works, for example, in 2026, let’s say you work at Google and you said, “Oh, I’m going to contribute $24,500 into my employee bucket.” Maybe it’ll be pre-tax, I’ll get a tax deduction for it. On top of that, you can contribute after-tax money into your Google 401(k). For example, I’ll put another $32,500, right? It’s an after-tax 401(k). Similar to what we just said with the IRA, that 401(k), you can convert that $32,500 into the Roth 401(k), and that will now be—instead of growing tax-deferred, it’ll be growing tax-free.
Speaker 2: Same mechanism, you’re just—with certain employer accounts allow you to contribute more. What is the maximum I can contribute using a mega backdoor?
Speaker 3: The maximum that can be done into the 401(k) is $72,000 this year. Now that is combined between employee contributions and employer. So let’s say your employer doesn’t put anything in, you could put in up to $24,500 as employee pre-tax, and then the difference between $24,500 and $72,000 you could do as an after-tax contribution that you could then convert into the Roth bucket for the mega backdoor Roth.
Speaker 1: Does the pro rata rule apply to a 401(k), or is that just for an IRA?
Speaker 3: That’s a good question.
Speaker 4: I don’t think I’ve ever heard of pro rata for 401(k).
Speaker 3: I believe they look at the difference, right? So if you’re looking at your earnings, what you converted minus your basis is your earnings, and you would pay tax on that.
Speaker 2: Let’s say I get a $2,000 match from my employer and I put $20,000 into my IRA. I’m using this for easy numbers. And then I call up my HR department. I say I want to do a $50,000 mega backdoor Roth. Is my HR department going to look at me like they know what I’m talking about, or am I going to have to give them some help in order to help set this up?
Speaker 4: It depends, right? I don’t know who the HR is. They may know the answer, but a better person to ask is the plan administrator. So if your plan is with Schwab or T. Rowe Price, whoever it is, that would be the person to ask. And the question is, does the plan documents allow for that? Not all plans allow for mega backdoor, all that kind of stuff. So just make sure you ask the question about whether that’s allowed or not.
Speaker 2: That’s a little bit more of a project here than the backdoor Roth, because you probably have to go through your plan administrator or an HR department in order to set that up. Whereas the backdoor Roth, the mechanics of that can be done in an afternoon.
Speaker 4: Yeah, yeah. And the reason I believe they call it a mega is because it’s just a much larger dollar amount, right, annually compared to the $7,000.
Speaker 3: So again, the mega backdoor is something that’s allowed by the IRS, but you certainly have to check with your custodian, HR, employer to see if the plan documents allow it to do it at your work.
Speaker 1: Okay, so because you have potentially pre-tax and post-tax money in your 401(k), does the pro rata rule apply to your 401(k) as well for this mega backdoor Roth thing?
Speaker 4: It does for one of the pro rata rules, because remember we said there were 2. Right. The pro rata rule where, you know, I can convert my basis tax-free, not my earnings, that also applies to 401(k)s in the mega backdoor arena. But the other pro rata rule for the IRA concept, where any pretax money then taints it, that does not apply in the 401(k) world. So you could have other pretax 401(k). That doesn’t mean your conversion is subject to pro rata allocation. Only if there’s earnings.
Speaker 3: So I think in a typical scenario, somebody—maybe they have $10,000 of post-tax money, after-tax money, in the 401(k), they’ve got $15,000 of pre-tax money, so they’ve got $25,000 in there. If they go and convert it, they’re going to pay tax on whatever earnings they have in there. So the pro rata rule is definitely going to apply. It’s just going to be a matter of how much you’re converting and what’s your ratio for sure.
Speaker 1: Sounds like I need to talk to my CPA before I do any of this—backdoor or mega backdoor Roth.
Speaker 4: Yeah, I mean, I think I would go back to something that Scott said earlier, right? Which is, why have money growing? So if I’m doing the mega backdoor in my 401(k), I’m just going to contribute and convert in the same day or the next day to get rid of that issue.
Speaker 2: I would actually be quite surprised if many people have this problem, right? Because you’d have to be adept enough to set up a traditional account, which is neither a traditional 401(k) nor a Roth, and then also somehow created a situation where you did not immediately convert it within a reasonable period of time to have this problem. And if that’s you, then it’s time to call a CPA, I think, at that point to resolve this problem. But for everybody else, do not give yourself that problem. There’s no reason to do that. You just—like, if you’re going to use these accounts, convert it immediately. And obviate this pro rata situation entirely, I think. Is that, is that the right takeaway?
Speaker 4: Yeah, the 2-step process, just do it at the same time, guys. Yeah, even though I know we keep saying it’s 2 steps, but just do it at the same time.
Speaker 3: I think it’s worth mentioning, right? Think about the power of that, right? Because you gave that example earlier, Scott, right, where someone’s put $20,000 in, their employer put $2,000 in. Now, in a typical scenario, maybe that’s all someone was typically doing for retirement, but if they’ve got a lot of excess money that they’re not using or not earmarked for something else, they’ve got that $50,000. Think of the power of being able to contribute an extra $50,000 essentially into a tax-free environment and let it grow tax-free for the rest of your life versus only putting $20,000 in, right? So the compounded growth on that’s going to be huge.
Speaker 2: So this is where, you know, we know—we talk about the backdoor Roth, we talked about the mega backdoor Roth. And so now I want to put it together and say, what is the optimal order of operations for a high-income-earning household that is primarily W-2 here. And so I want to spit this hypothesis out for your guys’ feedback. So first, take your employer match. That’s going to vary by your employer, but take it. That’s the first step. The second is—this is very heavily employer dependent—but take the employee stock purchase plan option, which can often be better than the next contributions to your retirement accounts, depending on the terms of that, especially if you can sell it immediately for a big gain, like a 15% discount. Number 3 is max your HSA. Do that before any of these mega backdoor, backdoor Roth craziness if you’re a high-income earner. Number 4 is max out the 401(k) contribution or contributions, $24,500 each for each household member, because we’re a high-income household. Next is ask your HR department if your employer allows after-tax contributions with in-service Roth conversions, or ask them about the mega backdoor Roth. If they look at you with a funny face or refer you, then ask your IRA custodian for your company how to do that—if that’s, for example, Justworks or whatever, Fidelity at your company. Know that the max contribution is $72,000 less your employer match and your 401(k) max per person. After that, you can also do a regular backdoor Roth on top of that. Do that for both spouses. And then from there, you can consider something like a 529 plan, but you’ve largely gone through the optimal stack at that point in that order. That’s about $165,000, or a little bit more than that actually, if you have gone through that entire stack for a married household. So that’s an elite level of savings and will cover most, even high-income earners, from a tax optimization standpoint. How’d I do? Is that, is that pretty close? Is that the way to implement this in order?
Speaker 4: Yeah, I mean, I love the HSA towards the beginning, right? Because that’s one of the few types of accounts where we get a tax deduction for the contribution going in. It grows tax-free and it comes out tax-free for medical. So definitely, you know, a very superior investment product or tax optimization vehicle. The only thing I might tweak on that is I probably put the $7,500 Roth IRA before the after-tax 401(k), or, you know, the Roth 401(k). And the reason for that is because for high-income earners who—you know, depending on how much money they’re making, what their goals are, right—I always want to put money into the backdoor Roth because I wasn’t getting a deduction anyways. It’s going to grow tax-free. I’d rather have it grow tax-free than taxable. But when we talk about retirement contributions into the work 401(k), you do want to take into consideration pre-tax versus post-tax retirement account. So that part, probably I would encourage people to put more thought into it when they meet with their CPA, because Roth is great. Roth is great for tax-free money that’s growing forever. But just make sure you understand what you’re giving up in terms of current deductions.
Speaker 2: I think you’re right to correct me on that as well. For another reason I didn’t think of until you just said that, but the plan—in a Roth, like let’s say you go with Schwab or Fidelity for a Roth that’s directly controlled by you, those typically you can invest in ETFs with much lower fees than what your employer plan is going to offer, which often has very expensive fees there as well. So I think you’re—I think you’re completely right. And I’m going to flip that order here. I think that was—that’s really good input.
Speaker 3: I mean, that—I think what you went through is worth its weight in gold. Like, I think you should save that for the stage at maybe BPCon or something, you know, that might be a suggestion. Charge money to listen to it.
Speaker 2: Yeah, I think that’s for high-income earners. It’s not good for real estate. It’s not good for maybe some other entrepreneurial stuff. There’s different ones there. But I think this is how I would think about using these tools in the context of an elite-income household. A couple of notes here as well is one, you would—if you have a dependent care FSA through your employer, that belongs higher in the stack, probably before you even max out the 401(k), I would argue. And then if you cannot qualify for or cannot justify because of your health situation an HSA-compatible healthcare plan, then a healthcare FSA would swap with that. Is that—do you guys agree with that as well?
Speaker 3: I think a lot of people know this, but those FSAs, you just got to be careful of the use-it-or-lose-it features in there, right, where you’re not letting money just go to waste because, hey, I set aside as much as I could, but then I don’t have the medical expenses I needed, right? So you just got to be—keep an eye on that. But yeah, I love those for sure.
Speaker 2: How do you think that going through a stack like this and using the backdoor Roth, or mega backdoor Roth in particular, changes the trajectory for financial independence?
Speaker 4: I mean, it depends on the age of the client, right, or person we’re speaking with. I mean, if they’re super young, it doesn’t really help them reach financial independence any sooner because we just now have—we say—$150,000 tied up in an account. That’s going to be amazing once you reach retirement age and can access it, but it’s not really going to help you replace your W-2 income anytime soon to stop working. If we’re talking about someone who is older, closer to retirement age, then yeah, sure. I think those are maybe 2 different things, right? Financial independence to me is sort of like—how can I have more passive income, investment income today where I can utilize, which is different than just the theory and the talk around retirement accounts in general, which is saving for the future, right? Benefits in the future.
Speaker 3: I think like from my angle, a different way to look at it, right, is I think it’s you’re setting up those habits, those good habits of putting those things in place. And because I’m going to date myself, but when the Roth IRA came out, I was a junior or senior in college, and our tax professor—I mean, she was hammering it over our head every day about the Roth IRA. She’s like, “I can’t believe they’re doing this. Like, you guys need to do this every single year. Don’t be a moron. Don’t be an idiot. Contribute to it while you can.” And so I go back to that. It’s just the habits of do this checklist of things every year and you’re going to set yourself up for that future where you’re going to have that financial independence at some point in the future.
Speaker 4: I don’t know if you noticed, Matt said twice today already, like, I don’t want to date myself.
Speaker 1: I never want to date myself. It always happened when I was in college.
Speaker 4: Were you born in the ’30s?
Speaker 3: I’m 25 years old, everybody. I’m 25.
Speaker 2: That’s why you’re maxing the Roth.
Speaker 1: So would my backdoor and mega backdoor Roth money that I’m putting in count as a contribution that I can then withdraw at any time? Because you can always withdraw the contributions at any time.
Speaker 3: With the backdoor Roth, with a Roth IRA, you are always allowed to pull money out. So your contributions to the Roth, you can also pull out money that you’ve paid taxes on. There’s some, there’s some limitations, but generally speaking, you can always pull out your basis. And so that is a nice flexible feature of Roth IRA that if you do need money prior to retirement age for any reason, like an emergency or something, hey, I’ve got $20,000 of basis in my Roth IRA. I can pull that out and not have to worry about taxes or penalties. That is a pretty cool feature for sure.
Speaker 1: So the $50,000 that I’ve put in through the mega backdoor Roth, that counts as basis, and I could just snatch that out. So if I’m making super high income throughout my, let’s say, my 20s and 30s, and then I retire at 40, I can start pulling that out at around $50,000 a year, because that’s my basis, whatever my basis is.
Speaker 3: The hurdle with the employer plans, the 401(k)s, is that again, we go back to that concept of the plan document’s got to allow you to take these distributions out. So just because, again, the IRS says maybe you can do that, the plan document says, hey, you know, if you’re not 59 and a half, for example, you can only pull it out for A, B, or C reasons, that you might run into some hurdle like that.
Speaker 1: Oh, okay. Thank you for clarifying that.
Speaker 2: One contradiction I want to talk about with this entire conversation, which I think is important because it’s actually relevant to the entire strategy, is the person who’s going to be using the backdoor or mega backdoor Roth is by definition a very high-income earner, right? They’re going to have income over the limits that allow for regular Roth IRA contributions. And in that situation, it is generally going to be best practice to defer taxes, right? That’s going to be the bias we’re going to come in that this is, we’re actually in a relatively high-income-earning year across our lifetime. And later in life in retirement, we’re going to be in a lower tax income bracket. That’s where that order of operations I just talked about is really important. We’re going through the pre-tax or tax-deferred stack first with the HSA and the traditional contributions and maxing those before we go through the Roth contributions in this particular case. Now, if we were much younger and lower-income-earning and expected our portfolio to grow massively, or we’re very confident that we’re going to become so rich that we’re going to be in a high-income tax bracket for the entirety of our life, then maybe that changes for the Roth contributions. But do you guys agree with that as a grounding mechanism? This is for a high-saving but also very high-income-earning household after they have gone through the pretax stuff.
Speaker 3: Certainly, yeah. And obviously, some of that requires a crystal ball that a lot of people don’t have. But the funny thing is you’ll ask people like, hey, do you think you’re going to be making more or less money at retirement age? And obviously, most people are going to think—they’re going to say they’re going to be making more money, right? So you certainly have to take that into consideration in terms of, yeah, if you’re at a high income, it’s really hard to bypass that $24,500 pre-tax deduction you’re going to get on your employee contributions to your 401(k), and say, hey, I just want to do that into the Roth bucket and bypass my deduction. It’s a hard pill to swallow, but certainly want to have that conversation with your team of advisors.
Speaker 2: Is there any argument to put the college savings before this in certain situations?
Speaker 4: Like an ESA account, 529 plan.
Speaker 3: I’m sure there’s, there’s an argument somewhere. I kind of fall back to like, you know, we’re talking about retirement for you, right? Like for you, the parent. And you know, when you get to 70, 75, 80 years old and you’re going to need your money to live off of versus relying upon your kids’ money at that point in time. So I kind of tend to fall like, let’s take care of ourselves first.
Speaker 4: Maybe that’s selfish, but I mean, I will say 529 plans work really well the younger your kids are, right? Because my kids are already going to go to college next year, I’m getting one year of tax-deferred growth. It also works really well for our clients who just have a lot of money in their brokerage account. If I have a lot of money in my brokerage account growing in a taxable environment, then I would consider a 529 plan because I’m still having money growing in brokerage, but now it’s just growing tax-free because I’ll be using it for college, you know, five to seven years.
Speaker 3: Or maybe even best of both worlds. Maybe you’ve got your money, you’re doing that kind of stack you were talking about, Scott. But then, you know, grandparents have got some money on the side and they want to help their grandkids set aside money for college. They can put their money into the 529 plan while you’re putting your money into your own retirement.
Speaker 4: I like that one.
Speaker 2: That’s a good situation, right? I work at Google, I make $500,000, $600,000. I am able to go through my entire stack, crush all that, have a little bit left over to spend on a nice life, and grandparents fund college education. Life is good.
Speaker 3: Hey, grandparents, you don’t need that money. You don’t need that money.
Speaker 2: So I love it. Probably not unrealistic in some scenarios for that.
Speaker 3: I think I’m talking out of both sides of my butt. I don’t know.
Speaker 2: That would be a great situation. So I guess if you can do it, then you also want to front-load potentially the college savings and have that grow tax-deferred in the 529. But I think for most people, it’s going to be the rare person who’s able to go through that entire stack and make the max contributions to the 529, or even catch the five-year front-loading or whatever.
Speaker 3: Life goals, right?
Speaker 2: So that’s a good year. That’s your SpaceX stock IPO sale year that you go through that whole stack.
Speaker 1: Wait, say that again. What’s that whole stack for that SpaceX listener?
Speaker 2: The hypothesis, just for fun with our tax pros here—this will be timely because the SpaceX IPO is coming out soon—you take your employer match, you continue to take advantage of your employer stock purchase plan, which is exploding in value right now. If there’s options in there, it depends on the circumstances. You max out your HSA, you max out your dependent care FSA if you have kids, you max out your 401(k), you do your personal backdoor Roth, then you do your mega backdoor Roth with your employer or your IRA custodian. Then you fully fund your kids’ retirement accounts, which I think is up to five years of contributions you can frontload. And that will likely defer state taxes depending on where you’re at, but not federal. And then you have whatever is left over. That would be my stack for the SpaceX IPO employee. I don’t know, that would be the first hypothesis. What do you guys think?
Speaker 4: I love it, except let’s swap out the 529 contribution to be from grandma instead of us.
Speaker 2: So we pay taxes but buy half a Tesla with the savings.
Speaker 4: Half of a Tesla.
Speaker 2: Yeah, the Californians are all selling their Teslas in the last few years. So I want to leave us with a parting thought here. I want to ask the audience—this was a backdoor and mega backdoor Roth discussion. Amanda and Matt, you guys added a ton of value here, thank you for walking us through this. Another strategy I’ve been noodling on is if someone has a huge amount of money in their 401(k)—let’s say they spent 20 years contributing to that, they haven’t been able to go through this whole stack because they’re not uber rich, you know, and making so much money they can go through it. So they’ve been prioritizing the 401(k), taking the match, and they’ve got $1.5 million or $2 million in their late 40s or early 50s in there, and little wealth outside of that. Some, but not really meaningful amounts. Can you buy a nice rental property, accelerate depreciation, manufacture a major loss in the first year or two of early retirement, invest in certain types of assets that are very tax efficient for a rollover, and convert that to a Roth in a big move? And is that a very powerful strategy for a lifetime employee? I want to ask if people are interested in that, if anybody knows anybody that’s done that. And then I would—if we want to have Matt and Amanda back on to talk about that.
Speaker 3: We would love to be back on to talk about that.
Speaker 4: For sure, we can’t answer the question.
Speaker 3: That was a teaser.
Speaker 4: Oh, man.
Speaker 2: Let us know if that’s an interesting one, and we’d love to hear a story of someone who has done that or has executed some version of that in the past as well.
Speaker 1: Do you have to have real estate professional status in order to accomplish this, Scott?
Speaker 2: That’s a question for Amanda and Matt.
Speaker 3: That’s a question for when you come back.
Speaker 4: Oh, yeah, well, we’ll tell you on the next episode. So yeah, and we do have clients who’ve done that for sure.
Speaker 1: Oh, okay, we’re going to have to talk about that because, yeah, Scott, feeling a little seen here with your comment about prioritizing the 401(k) for current year tax deductions instead of looking forward. And the reason you would do this is so you get money out of your 401(k) into the Roth account to let it continue to grow. But every dollar that you pull out of your traditional 401(k) and put into a Roth is no longer subject to RMDs when you turn 73, or whatever age you’ll have to take RMDs at.
Speaker 2: I think this is a very first-world problem impacting a good number of people who listen to personal finance podcasts instead of the Chainsmokers during their workouts and commutes. So I’d be interested to see if that’s a shared view by the community. So, Amanda and Matt, thank you so much for coming on and sharing your wisdom today. Where can people find out more about you?
Speaker 3: Yeah, thanks for having us, guys, this was super fun. Best place to find us is our website, keystonecpa.com. We have a lot of great resources and free information on there. Some of these topics, we actually have some stuff on there as well.
Speaker 4: So yeah, best place to find me is probably Instagram and also YouTube as Amanda Han CPA.
Speaker 1: All right, Amanda and Matt, thank you so much for your time today. I always learn a lot when I’m talking to you. And now I’ve got to go talk to Carl about our backdoor and mega backdoor Roth scenario. So thank you so much for giving me some homework and for giving our listeners some homework. We will talk to you again soon.
Speaker 4: Thank you.
Speaker 1: All right, Scott, that was a whole lot of information that Matt and Amanda threw at us. I really enjoyed this show. I know I have a ton of homework to do. I am actually going to write an article for our newsletter and our blog detailing, based on what Amanda and Matt said, how to do the backdoor Roth and the mega backdoor Roth, because I think this is a really awesome strategy for people who are on their path to financial independence. What did you think of the show?
Speaker 2: I thought it was great. I think that there’s a lot of technical detail there. I think that the hardest thing about the backdoor and mega backdoor Roth is the complicated or technical-sounding nature of it, and the very real idiocy—I’m going to use that word to describe the interim account that has no value and actually can be a complicating factor, a pain in the rear if you leave any money in it, in this interim account. So it’s the traditional account that’s neither pre-tax nor Roth, that you have to contribute to, to then roll over into a Roth, or use in parallel with the mega backdoor Roth strategy. That’s a very silly rule. It just is. And it allows any high-income earner to get around these arbitrary limits to the Roth conversion. And I think that’s the hardest mental reframe to getting over with this strategy and using the tool.
Speaker 1: Yeah, I think if you’re going to do this backdoor or mega backdoor contribution, get in, do the contribution, and then immediately convert. Don’t even wait a day because maybe the market has a great day. I mean, yeah, what a horrible problem, you have to pay taxes on $27. But don’t complicate your life. Hit it, get it done, and then immediately convert. That should be the order of operations for that.
Speaker 2: Otherwise, you’re going to be in a really long conversation with a CPA that’s going to cost you hundreds of dollars in order to solve your pro rata $27 problem here. It’s just, this is a two-step process, and it should be instant.
Speaker 1: Yeah, that’s it. Just put it in your mind: this is a two-step process that happens instantly. And my dear listeners, do you want even more financial independence information? Head over to biggerpocketsmoney.com and sign up for our newsletter. I send it out once a week with articles just like the one that’s coming out next week, talking about the mega backdoor Roth and the backdoor Roth. We also have a ton of free resources, calculators, and templates to help you on your journey to financial independence. All right, should we get out of here, Scott?
Speaker 2: Let’s do it.
Speaker 1: That wraps up this amazing episode of the BiggerPockets Money Podcast. He is Scott Trench. I am Mindy Jensen saying, stay sweet, petite beet.
