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White Coat Investor Podcast
WCI #430: Backdoor Roth - Standard and Mega
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Today we are talking about everyone's favorite topic - the Backdoor Roth! We are answering questions about common mistakes for the Backdoor Roth IRA as well as having a larger discussion around what the Mega Backdoor Roth is, who it makes sense for,...
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Tyler Scott
This is the White Coat Investor Podcast where we help those who wear the white coat get a fair shake on Wall Street. We've been helping doctors and other high income professionals stop doing dumb things with their money since 2011. Hello everyone and welcome to episode 430 of the White Coat Investor Podcast. Today's episode is called Backdoor, Roth, Normal and Mega. Today's episode is brought to us by SoFi, the folks who help you get your money right. Paying off student debt quickly and getting your finances back on track isn't easy, but that's where SoFi can help. They have exclusive low rates designed to help medical residents refinance student loans and that could end up saving you thousands of dollars, helping you get out of student debt sooner. SoFi also offers the ability to lower your payments to just $100 a month while you're still in residency. And if you're already out of residency, SoFi's got you covered there too. For more information, go to sofi.com whitecoinvestor SoFi student loans are originated by SOFI bank and Amember FDIC. Additional terms and conditions apply and MLS 696891 my name is Tyler Scott and I am one of the friends of WCI here standing in for Jim today and excited to talk to you about some backdoor Roth questions, both the traditional version and the mega Backdoor Roth at work. And before we get started on that, let me just first say thank you so much for all that you do out there. We know that our target audience is those wearing the white coat, the physicians and dentists. But we know that's not our only audience. We know there's all kinds of you out there doing important work, making sacrifices to make our community better. We see you, we appreciate you, we are grateful for what you do. And wherever you're listening today, whether you're in the car or you're on a jog, at the gym, or if you're at work. Thank you for taking time to spend time with us and for making contributions to our community here in the white coat world and our community at large. Making society a better place through your efforts. Our quote of the day today is from Susie Orman. A big part of financial freedom is having your heart and mind free from worry about the what ifs of life. And that is so true. Money is many things and one of the things when utilized best is the ability to utilize our bandwidth for the things that bring us the most joy and to have peace of mind about what's going on in Our life gives us the choices to do what we want with our time and to feel less stressed. So agree with Susie on that one. All right, well, without further ado, let's get started on our questions and take our first question off the Speak pipe. Hi Jim, I was hoping you could help me with my first time doing a bacter Roth ira. I contributed $7,000 to a traditional ira, with part of it coming from my bank and part of it coming from a taxable brokerage account that we decided to convert into the Roth IRA this year before it all got there. It did earn $0.33 of interest and that did get rolled over into the Roth IRA. So there was $7,033 converted from a traditional IRA to a Roth IRA. I called Vanguard to see how I could fix that extra 33 cents and they said that the conversion from a traditional to a Roth is does not have a limit. I'm a little confused, but he reassured me that it would be $0.33 taxable event, but otherwise there wouldn't be any penalties. I was just hoping you could confirm that and help me understand if there's anything I need to do to retract that extra 33 cents that again was contributed to a traditional IRA and then rolled over to a Roth ira. Thanks. Wonderful. Great question. Really common question. First, congratulations on doing your first backdoor Roth contribution. That's so fun. And the fact that you've educated yourself to the point of being able to even ask this question is a great sign for your financial future. Also, I understand your concern here. You want to do this the right way and follow all the rules, not just to stay out of trouble, but also to do the right thing. One thing I appreciate a lot about our WCI community is a consistently high ethical standard. I'm continually impressed and inspired by the questions we get that demonstrate people's commitment to integrity and the value we all place on doing the right thing, even when no one may be paying attention. And believe it or not, the IRS is often not paying attention when it comes to some of these details. That doesn't mean we shouldn't all seek to abide by the laws of the land and uphold the rules, even when the rules may be bizarre and the referee is asleep. So let's talk about this really common question related to the backdoor Roth IRA mechanics and why there's nothing to worry about in this case. If you want to read about this on the blog, Jim has a post called Pennies and the Backdoor Roth IRA that will talk you through it All. Okay, the steps for a backdoor Roth IRA are really quite simple, but it generates a lot of questions, which I think is totally reasonable because the whole backdoor Roth IRA concept is not at all intuitive. It would all be easier if we didn't have to use the so called backdoor. If we could just make direct front door contributions to our Roth ira, that would be awesome and we wouldn't get all these questions. But we can't. Or at least most of us can't. The US Congress has decided that if you make too much money, you can't contribute to a Roth IRA. Well, how much is too much in 2025? If you're single and your modified adjusted gross income, or MAGI, is more than $165,000, you can't make any direct contributions to a Roth IRA. If you're married, filing a joint tax return and have an magi of $246,000 or greater, you can't make direct Roth IRA contributions. So sad news for most listeners of this podcast. The good news is that there's a loophole, a workaround for this income restriction. In my opinion, the loophole makes absolutely no sense. It's not intuitive or logical at all. But I love it because it means my wife and I and all of my clients can maneuver our byzantine tax code to get money into our Roth IRAs each year via this loophole we lovingly call the backdoor Roth ira. That term is totally made up. By the way. If you search the IRS website for backdoor Roth, a thing is going to come up. It's just a conceptual term to describe the following steps of the loophole. Step 1 Make a non tax deductible contribution to a traditional IRA. Leave the money in cash. Don't invest it yet. Step 2 Convert those non deductible dollars from the traditional IRA to the Roth IRA. Step 3 Invest the money in the Roth IRA according to your written investment plan. And four fill out Form 8606 completely and correctly and file it with your tax return each year. That's it. That's the loophole. Those are the steps. This caller knows all that and is just getting caught up on step two. She made the maximum allowable contribution to the traditional IRA for 2025, which is seven grand, and she left it in cash. Good job. Then a day or two later, she converted the entire balance of the traditional IRA to the Roth IRA, which was $7,000.33. Again, good job. She's just tripped up on the 33 cents. First, where did the 33 cents come from it is interest. Remember how we said to leave the money in the traditional IRA in cash? Well, at most brokerages like Vanguard, Fidelity and Schwab, the cash earns a decent interest rate. Right now that's between 4 and 5% a year. Well on $7,000. The daily equivalent of 4 to 5% was 33 cents in this case. Well now what? The 2025 limit is $7,000 and she is worried about breaking some kind of rule for exceeding that limit. I get this question from clients all the time. It just begs the question what limit? And this is where people get caught up. The limit is for the contribution, not for the conversion. The Vanguard rep who talked to her on the phone said as much as there is no limit on how much you can convert from your traditional IRA to your Roth IRA in a given year. And if you've listened to this podcast much, you already know this in the deep recesses of your brain somewhere because you've heard the questions we get on the podcast all the time from people considering doing a Roth conversion. Often these people are approaching retirement and have cut back at work. Maybe they're already in retirement or other people are in a low ish tax bracket for some reason like taking a sabbatical, going back to school, being in training or something like that. These people want to take advantage of their low tax bracket by moving money from a pre tax account like a 401k or rollover IRA to their Roth IRA. Well this is a taxable event because the money is being moved from a pre tax universe to a post tax universe. Given that taxes will be owed on the conversion of this money to the Roth ira, people call in and ask us hey, how much should I do as a Roth conversion? Or when should I consider a Roth conversion? All of this is to say that the Vanguard rep was right that there is no limit on how much you can convert to your Roth IRA at any time. If you want to move $5 million, no one's going to stop you. You just need to understand how much in taxes you're going to owe on that conversion. Well that brings us back to our 33 cents in the backdoor Roth steps. Given that step one was to contribute $7,000 of non deductible after tax money, do we owe any taxes for moving that post tax money to a post tax account like a Roth ira? No we don't. Did we break any rules by contributing more than the annual $7,000 limit? No, we did not. But if we have any earnings on our $7,000 between the time of the contribution and the conversion. Do we owe taxes on those earnings? Yes, we do. Is there a limit on how much we can convert to our Roth ira? No, we just covered that. There's no limit on the conversion amount. So can we convert $7,000.33 to our Roth IRA without breaking any rules? Yes, absolutely. It just begs the question, how much do we owe in taxes that? Well, $7,000 was a tax free conversion because it was already after tax dollars. But we do theoretically owe ordinary income taxes on the 33 cents of growth. I say theoretically because in reality we don't report cents on our tax returns. So when you fill out form 8606, 33 cents rounds down to zero. So in this caller's case, there is no tax due for the $7,000.33 conversion. But what if it was $0.87 or $5 or $20 of interest that had accumulated? You just owe taxes on that growth amount. So if your marginal tax rate is 40% and you convert $7,005, you owe $5 times 40%, which equals $2 of taxes. No big deal, right? Didn't break any rules. The backdoor Roth police aren't coming to your door. You just have to pay your taxes on the extra amount that you converted due to growth. Alternatively, you can leave the $0.87 or the five bucks in the traditional IRA, but that will complicate your or your CPA's task of filling out Form 8606, and it'll make you subject to pro rata calculations on future backdoor Roth conversions. I've already talked too long about this simple question, so I'll spare you a discussion about Line 6 of Form 8606 and the Pro rata rules. You can go read all about that on the blog. But for now, suffice it to say that it's much easier and cleaner to get your traditional ira down to zero bucks before December 31st each year. That leads me to a final point. In the caller's case, she was able to see the 33 cents of interest before she completed her conversion, which is actually kind of nice. Like, at least she knew it was there. The more annoying version of this problem I see all the time with clients is they put $7,000 in the traditional IRA on January 2nd, they convert the entire balance on January 4th, and that balance still shows as $7,000. And so they think they're good to go. But then when they send me their account balances in June for our annual meeting. I see the traditional IRA has $1.68 in it. And I tell them, hey, you should clean this up, or your Form 8606 will be a little wacky and the pro rata rules can apply down the road. And then they say, what the heck? I converted the entire balance of the traditional ira, and when I was done, there was no money in there. Where did this dollar 68 cents magically come from? The answer is that it was an interest payment made in arrears. Often these brokerages don't make daily interest payments, but they do it weekly or monthly. So on January 9, they look back and say, well, how much did Joe have in his account last week? On January 2nd, looks like he had 7,000 bucks in there. We owe him $1.68. Then they put the interest payment in long after you think you've emptied out the account, so look out for that. I always log into my traditional IRA on, like, December 1st each year just to make sure it's at zero. So, in short, don't worry. If you convert a little over the $7,000 contribution limit in a given year, you'll owe a little tax on that. Just make sure to get your traditional IRA to zero by the end of the calendar year, so your paperwork is easy. This is the easiest of the backdoor Roth IRA mistakes to fix. Okay, let's listen to a question from Gabriel, a new Attending who made another common backdoor Roth IRA mistake. This one is a little more complicated to clean up than the Last one. Hello, Dr. Dali. My name is Gabriel. I'm an allergist. I recently started working as an Attending in Seattle, Washington. My question is regarding excess contribution for a Roth ira. I contributed to a Roth IRA for this tax year. I'm realizing my income will be above the limit for contributing to a Roth ira. So now I'm looking into removing the excess contribution or recharacterizing it into a traditional ira. I don't have a traditional IRA at this point. If I recharacterize it into a traditional Iraq, I was wondering if I would be able to immediately afterwards do a backdoor Roth conversion or if I should just remove the excess contribution first and then later on attempt the backdoor Roth conversion. Seems like it should be straightforward to just do the recapturation to a traditional IRA and then do backdoor Roth. But I want to make sure I'm not missing something. Thanks for your help. All right, Gabriel, great question. And another common problem we see with backdoor Roth. Again, like the Last question. Let me say good job on making use of this loophole and great job on paying attention to the rules and self policing when you got it wrong. So the misstep Gabriel made here is one of benevolent exuberance. He was in such a good habit of funding his Roth IRA early in the calendar year as a resident and was so excited about funding it again in this last year of training that he made a direct contribution without thinking about the totality of of his 2025 income. This excitement has not been a problem for him in the past because as a as a resident his annual income was below the limits we mentioned in the last question. Gabriel didn't ever need to use the backdoor Roth loophole as a resident. But now, with a partial year of resident income and a partial year of attending income, he realized after the fact that his 2025 income will exceed the limits for direct Roth IRA contributions. In his exuberance to fund his Roth IRA earlier this year, he didn't pause to realize that even though he was a poor resident at the time of the contribution, that when taking the entire year into account, he would make too much money for that direct contribution. And now he needs to fix his ineligible or excess contribution. So this happens so often. I've written a blog post about it. It's called Backdoor Roth when your life is in flux. Jim has a post about it. It's called IRA I should have backdoor Rothed. So go read those. And in my post I point out a few common scenarios where you will find yourself wishing you had used the backdoor loophole. The most common situation is Gabriel's someone in their final year of training. You're so accustomed to being low income that you don't pause to realize that by the end of the year your income will exceed the limit. Another situation is getting married to another earner. Let's say you're a first year resident making $60,000 and you make your direct Roth IRA contribution in January and then marry an attending in July. Well guess what? Your tax filing for that year is going to be married filing jointly and your combined household income is going to be way above the income limits. And now your Roth IRA contribution is way back in January needed to have happened via the backdoor loophole even though you made the direct contribution when you were a well meaning low income single person back earlier at the start of the year. Similarly, those that divorce a non earner can be in the same boat. Consider a married earner with an MAGI under the married filing jointly direct Roth IRA income limits, but above the single income limits. So $200,000 works as a good example. Our married earner has become accustomed to making a direct Roth IRA contribution for themselves and their stay at home spouse each January. By the end of the year, the couple is divorced and both spouses are filing their taxes as single or head of household. The non earner has no problem here because they have a MAGI of zero. But our earner who thought they were making an eligible direct Roth IRA contribution suddenly finds themselves with an MAGI that exceeds the limit for a single or head of household filer. Another situation where I see this a lot is with clients related to student loan optimization when they're pursuing public service loan forgiveness for complex reasons that transcend today's episode. Just know that it can make sense for some couples to file their taxes separately even though they're married and living together. And this is so they can make the lowest possible student loan payments while one or both of them pursue forgiveness of their loans. While the MAGI limit for direct Roth IRA contributions begins to phase out between zero and $10,000 of income for married people filing separately. Unless agree that staying below $0 of income is mathematically challenging for a household. So consider a couple who under the married filing jointly income limits for direct Roth contributions. And they make their maximum Roth contribution each year in January, well in March of the following year. So like 15 months later they meet with Andrew at Student Loan Advice and learn they need to file their taxes separately for both the previous tax year and for the tax years to come. They have unexpectedly and unknowingly found themselves with ineligible contributions to the Roth IRA from both the one they did a couple months ago and the contribution they made 14 or 15 months ago. So now they've got two years of ineligible contributions. Contributions. This happens all the time with the demographic of clients I work with. This accidental direct Roth IRA contribution mistake can also happen to people who just end up making more money in a year than they expected to. This actually happened to me a few years ago when I switched from dentistry to financial planning. I had every reason to believe that the first year of being in this new job that it would be a low income year for us. As I got my feet underneath me and I built my client base. So I made a direct Roth IRA contribution for me and Megan in January of 22. It was to my great surprise and delight that it didn't take me nearly as long as I thought to hit my stride in this new world. And we ended up surpassing the Magi limit for direct Roth IRA contributions by the end of 22. Oops. That was a happy oops, but still an oops. And so it can happen in years where you just make more money than you thought. I've also seen it happen for those losing qualifying widow or widower status. This one's much more rare, but it does happen. What you need to know here is in the year of your spouse's death, you can still file your taxes married filing jointly. And for the next few years after that, you can file as a qualifying widow, assuming you don't remarry, have at least one child you claim as a dependent, and pay for more than half the cost of keeping up a home. Then after those two years, you have to start filing your taxes as single or head of household. Well, qualifying widow has the same income limits as married filing jointly for direct Roth contributions. So in that tax year where you lose qualifying widow status, if your MAGI is below the widow limit but above the single limit, you can find yourself having accidentally made an ineligible direct Roth IRA contribution. The point is, there are lots of ways where Gabriel's question is relevant. It's not just for those finishing training, though. That is the most common demographic who makes this mistake. Okay, Gabriel, so what are you going to do to fix this? First, don't stress too much. It's not that big of a deal to fix the error, and you're on the right track. The solution is to recharacterize your Roth IRA contributions into traditional IRA contributions and then start the backdoor process from there. To recharacterize is to say, oops, my bad. That's not what I meant to do. Let's turn these Roth dollars back into traditional IRA contributions. There's just a couple things to be aware of, couple pitfalls with IRA recharacterizations. First, just know this is going to require calling the custodian of the Roth ira, being on hold, filling out paperwork, and navigating a bureaucratic process that will eat up some of your time and raise your blood pressure a little bit. Next, know that any growth that occurs on the original ineligible direct Roth IRA contributions from the date of that contribution to the date of the recharacterization. That growth will be taxable income to you at your marginal tax rate as ordinary income. This can result in a few hundred dollars of tax being owed. And then finally, the deadline to complete a recharacterization is October 15th of the year following the ineligible contribution. So, Gabriel, if you made your ineligible contribution earlier in 2025, you have until October 15, 2026 to do the recharacterization. Just note that if you made an ineligible Roth contribution in early 2025 for the 2024 tax year, because remember, you have until April 15th to do your Roth contribution for the previous year. So if that happens, the deadline to fix the error via recharacterization would be October 15th of this year of 2025. And if you miss that deadline, you must remove the entire Roth IRA contribution along with any growth and pay a 6% pay penalty on the amount removed. So Gabriel, get your recharacterization done on time. Get those dollars into a traditional ira. Sounds like you need to open a traditional IRA first. Then just use those dollars to start the backdoor process from there. The moral of the story to everyone listening is when in doubt, just use the backdoor loophole. There's no penalty for using it if you don't have to. Most of you need to get good at doing it anyway and you can save a lot of hassle when life changes unexpectedly, as life is wont to do all right, next we're going to move from standard backdoor Roth questions to the world of the mega backdoor Roth. And I'm going to try something a little different with these three questions. And before I say what that different thing is, let me acknowledge that I know all of you listening are already disappointed that I'm not Jim and that I'm not. He's out today, but just know he's asked me to be here because while he loves this work and intends to keep doing it, he may not want to do it at this same pace forever. So with that in mind, the WCI team is curious to see if people like me, the so called friends of wci, can pick up some shifts here and there to lighten Jim's load and help him find the work life balance that we all see. Further, the White Coat team has given us guest hosts some license to be ourselves and do things a little different than just try to be mini gym, which would be a fool's errand anyway. So with that in mind, instead of reading or listening to the questions and then responding to them in a classic way for the next few, I'm going to offer up a kind of primer. I'm going to talk about the topic first and then use the questions to test our knowledge. I want you listening out there to learn a little about the topic first and then maybe be able to pause the recording and take a stab at answering the questions on your own. Based on what we've just talked about. Think of it as a see one, do one, teach one opportunity for all of us. As always, if you like it or hate it or hate or like anything associated with the podcast, email meganodcastinvestor.com and tell her what you think. She listens to all that feedback. They talk about it as a team and we try to make this a better experience for you. Okay with that preamble, let's talk about the Mega Backdoor Roth strategy. The big picture goal with the Mega Backdoor Roth is to use up all the tax protected space the IRS offers you each year in your 401 or 403. This limit, known as the 415C limit, increases each year with inflation. The limit for 2025 is $70,000 for those less than 50 years old. The 415C limit for those 50 and older. This year is 77,500. I just went to Jim's surprise 50th birthday party here at the house a couple weeks ago and I said congratulations on being healthy enough to still play hockey. And for the 7,500 bucks extra you get to sock away this year in the 401. Catch up contributions in your 401k and Ira are the best part of turning 50 if you're a financial planning dork like me and Jim okay, so the first thing you need to know with the Mega Backdoor Roth is that your 401 or 403 has to allow for this strategy and most plans do not. Maybe 10 or 15% of my clients have this option and they're all either in a custom solo 401k or a 401k or 403 provided by Fidelity. I'm not saying Fidelity is the only one that offers it. That's just the, you know me reporting from the streets. All the quote unquote regular W2 folks that have access to this, they all happen to have a Fidelity employer sponsored plan. So for this to work, the 401k or 403 has to have three sub accounts, a pre tax bucket, a Roth bucket, and an after tax bucket. Note do not confuse the terms after tax and Roth. Too many people conflate the concepts of after tax and Roth in this conversation. Those are very precise terms with very different meanings. In this case, if you call up some staffer at Fidelity and ask does my 401 allow for after tax contributions? They're very likely to say yes, your plan does allow Roth contributions. Boo Hiss. I hate that. That's not what I asked I know my plan allows for Roth contributions. I need to know if the plan allows for after tax contributions, which is an entirely different thing. So then you ask for a higher level account manager and eventually you get someone who knows what you're really asking for. So your plan has to have these three sub accounts, pre tax, Roth and after tax. And it has to allow for you to make after tax contributions to the after tax bucket. Then the plan must allow for you to convert the dollars in the after tax bucket either to A or the Roth sub account in the 401k or B to your own Roth IRA. When we move money from the after tax 401 bucket to the Roth 401 bucket, we call that an in plan conversion. Makes sense, right? You converted the money inside the plan. When we move money from the after tax 401 bucket to our own Roth IRA, we call that an in service distribution. Makes sense, right? We distributed money from the plan even though we're still in service to the employer. We didn't leave. We didn't get fired or quit or change jobs. So that's the lay of the land. But why are we even talking about this again? Remember, the goal for me at age 41 is to get $70,000 in my 401. So let's see how I can do it. Where is that 70 grand going to come from? The first $23,500 this year goes in as an elective employee contribution. I make that contribution on a pre tax basis, and most of you listening probably do too. The next slice comes as an employer match. I'm a W2 employee for my financial planning firm and I get a standard 4% match. So that's another like 6,500 bucks or so for me. That's also a pre tax contribution for most of you listening out there. So so far, that's $30,000 that we've got in the 401k for me, all pre tax. That's great. But I still have $40,000 of room left until I hit the 415c limit of $70,000 for this year. So how do I fill up that $40,000 worth of space? The answer is I make use of the mega backdoor Roth strategy. If my plan allows for it, I can contribute $40,000 on an after tax basis. I can then have the plan convert that $40,000 right away to the Roth sub account inside the 401 via an in plan conversion. Or I can use an in service distribution and transfer the $40,000 to my own Roth IRA. And there. Boom. I did it. I made full use of the 415C limit this year. So awesome. High fives all around, right? Amazing. So I just gave an example of the most common use case for the megapackdoor Roth. That case is a W2 employee whose own maximum employee elective deferral contributions plus their employer match equals less than the annual 415C limit. The next most common use case is for self employed people with a Solo 401. These folks, the basic ideas are still the same. They start by making their maximum elective employee deferral contribution of $23,500. Next is their employer contributions. Well, they are their own employer, so how much can they put in the 401? From the employer side, the answer for sole proprietors and LLC owners is 20% of your net business earnings. For S Corp owners, the answer is 25% of your W2 salary from the S Corp. So the big point here is whether or not a self employed sole proprietor and LLC owner can max out their 415C limit from just normal employee and employer contributions is a function of their net business earnings. For an example, if an LLC owner has net business earnings of $150,000, they can contribute 20%, which is $30,000 as an employer contribution. Combine that with their $23,500,000 of employee contributions and they've put in $23,500. Well, bummer. That's $16,500 short of the 415,000. So like sad emoji there, right? We're bummed about that. But wait, all is not lost. The mega Backdoor Roth can still ride in on a white horse and save us here. If you've set up your solo 401k to allow for after tax contributions and in plan conversions, you can contribute the other 16,500 to hit the 415c limit. Awesome. Happy emoji. Now what if our LLC net business earnings are $400,000? Well, 20% of that is $80,000. Can we put the entire $80,000 in as an employer contribution? No, no we can't. That's more than the $70,000 415C limit. So how much can we put in? Well, we already did the $23,500 of employee contributions, so that leaves us with 46,500 to put in as the employer. Yay. Happy times. We filled up the 415C limit. No mega backdoor Roth needed in that case. Well, what about all you S Corp owners out there who are excited about taking part of your income as a K1 distribution so you can reduce your FICA taxes. What does that math look like for you? Well, remember your employer contributions to your solo 401k are 25% of your W2 salary. Now as we said a minute ago about our LLC and sole prop friends, all is not lost if your salary is too low to max out your employer contributions. You can still max out your solo 401 by making after tax contributions and converting those to the Roth sub account. If you've set up your 401 accordingly, note that cookie cutter off the shelf plans from Fidelity and Schwab don't allow for this, so you'll want to set up a custom Solo 401K with one of the providers we list on the Recommended tab on the website under Retirement Accounts in hsa. Okay, so we just fleshed out the next most common use case for the mega backdoor Roth the self employed person that has inadequate W2 salary from their S Corp or inadequate net business profits from their LLC to max out their annual 415c limit. Another use case is for the W2 employee that has a self employed side hustle. We'll tackle that one in our last question here in a few minutes. Okay, this is a good time for some disclaimers. I'm giving really broad and general advice here. I am not a cpa, let alone your cpa. The actual mechanics and details of this stuff are complex and not a DIY project. In my opinion. You should work closely with a tax professional and dare I suggest a financial planner to make sure you know what your net business profits are, what a reasonable salary is for the job in your city, and all the myriad complexities that surround this world like the wildly confusing QBI deduction, just to name one example. Another short aside here for my S Corp friends out there, I know that you and your CPA are super stoked about getting your salary as low as possible to reduce your Social Security and Medicare tax as low as you can get it. I love that for you this is just an invitation to make sure of two things. One, don't take a salary so low as not to be able to pass the reasonable compensation standards set by the irs. There's not much guidance from the IRS about how they define reasonable, but from cases in the tax courts we know that one definition of reasonable is how much you would need to pay someone to hire them for this job. So if you're a 1099 anesthesiologist and your S Corp salary is 90 grand. That's pretty sketchy and super scary in my opinion, and I think you should be setting money aside to cover the very plausible audit and the penalties that'll come with it. Number two invitation here is don't get so fixated on driving your FICA taxes down and with that super low salary that you miss the opportunity to max out your solo 401k with pre tax dollars from the employer side. Saving $4,000 of FICA taxes at the cost of deferring $20,000 of income taxes is not necessarily the most optimal long term strategy. This is one of the most common misses I see with S Corp clients and their approach to taxes. Again, every situation is different and this should all be worked out in great detail with your accountant every year as the math and the rules are constantly evolving. Okay, with all that framework in mind, let's tackle our first Mega Backdoor Roth question together. This one comes in via email. A couple weeks ago you talked about setting up mega backdoor Roth 401. You mentioned there had to be three sub accounts, one pre tax, one, one post tax and one Roth. Then you outline the steps of contributing to the post tax account and converting it to the roth account for 1099 people who set up their 401s through an outside party. I used my solo 401 that I know you used before. Jim. Can you just write a check from the business to the Roth 401sub account and not have the after tax subaccount? I met with my accountant and she said you can contribute the employee and employer contributions directly to the Roth 401K. She said that is not a Mega backdoor Roth when you do it like this. So I guess my question is what's the difference? Why do we need the extra sub account and the extra step? What's the difference between Mega backdoor Roth and just contributing directly to the Roth 401 as an employee and employer? Okay, good question. Let's tackle those questions one at a time. Okay friends out there listening. Why do we need the extra sub account and the extra step? Short answer because that's the only way for some self employed people to max out their 415c limit. Do we have enough information from this particular emailer to know if he needs the after tax subaccount and associated mega back to a Roth strategy? No, we don't know. We don't have enough information. What additional information do we wish the emailer had included to help us give a more precise answer? Pause for you to think about it yes, good. We wish we knew how old this person was because that impacts their total contribution for the year, right? Are they 50 or older? We wish we knew what type of business entity they had. As we just pointed out, the math is different for LLC folks and S Corp folks. And third, we wish we knew what their net business profits were if they ran an llc. Or we wish we knew how much their salary was if they ran an S Corp. So what can we say to this smart, albeit incomplete question? What would you say if someone asked you this at a dinner party? I might say, well, if you make enough via salary or net business profits to contribute the 415c limit for your age without needing after tax contributions, then awesome. You don't need the extra sub account and the extra step. Alternatively, if you don't make enough, then you do need after tax contributions and the sub account and the step. That's for you and your accountant to figure out at the end of the year once all your salary or profits are known. Okay, next question from the emailer was what's the difference between the mega backdoor Roth and just contributing directly to the Roth 401K with employee and employer contributions? Well, this is kind of a different version of the same question, right? What's the difference? Well, the difference is whether or not you make enough to fill up the 415C limit without making after tax contributions, or whether you need the mega backdoor steps to get there. Now to be fair, there is some additional color here I didn't speak to earlier that the emailer may be referring to. Note that they mention Roth employee and Roth employer contributions. Employee contributions have long been allowed to be either pre tax or Roth, but the Secure 2.0 act now allows for employer contributions to be either pre tax or Roth. Prior to the law being passed, all employer contributions were pre tax. So the emailer may be asking or making the point that assuming they make enough, they can just get $70000 of Roth contributions into the 401k without mega backdoor Roth steps. And that is a good point. After Secure 2.0 you don't have to use after tax contributions to the Roth. You don't have to do that maneuver if you want to make $70,000 of Roth contributions. Now that said, I have not seen seen many plans out there in the wild that actually allow for this yet. Just because the Secure 2.0 act allows it does not mean that any plan you encounter is going to actually have that set up. And I haven't seen any yet. Okay, do you guys want to hear what Jim's email response was to this person? Of course you do. So let me just read what he emailed them back. Okay, Jim said yes. Both the employee contribution of 23,500 and the employer contributions 20% of net income can now be Roth. Whether that's enough for you to get $70,000 in there or not, I don't know. Depends on how much you make. If so, no point in doing mega backdoor Roth contributions. If not, then you will still need that third sub account. But it's not a huge deal to have a third sum account. It's not like my solo 401k charges you extra for that or something. Every one of our employees has a third sum sub account and nobody has any money in theirs for longer than a day. So that was Jim's much shorter answer than mine. Okay, let's go to the Speak pipe for the next question. Well, this isn't really a question per se, it's a comment that is applicable to our conversation. Maybe it'll help codify some of our learning so far. So let's hear Brian's comment.
- [44:09]
Brian
This is a comment on the podcast that dropped Thursday, June 12. One of the questions was from a gentleman who was trying to figure out if his plan had an after tax option that could then be used to fund a mega backdoor Roth. Two questions that he should ask his benefits team were if the plan actually allows post tax contributions and if those contributions can be rolled into the Roth portion of the 401. Another question to ask would be if the plan allows in service distributions. If it does not allow in plan conversions to the Roth portion. Some plans, mine included, do not allow direct conversions of after tax 401k money to the Roth option, but they do allow in service distributions. They can then be sent to an IRA and then converted to Roth from there. Hope that helps. Thanks.
- [45:08]
Tyler Scott
So obviously no question there from Brian, but I play this for two reasons. First, Megan has been thinking about the idea of not just soliciting Speak Pipe questions from all of you, but asking for your comments as well. You are smart, engaged, diverse and well spoken bunch out there and we think including your perspectives, opinions and ideas could add valuable color and texture to the podcast. The idea is that just like Brian, you leave a Speak pipe in reference to a specific question on a specific podcast episode and offer your two cents. The speak pipes are still limited to 90 seconds, so we're not looking for a soliloquy here, but we're interested in your commentary. We don't claim to know everything, and we certainly can't speak to every cultural, geographic, gender, career, or personal perspective on a topic. So let's give it a try. If you notice something we missed, something we glossed over, something you have a different perspective on, something you think we could have explained better, or maybe most interestingly, something you disagree with, drop us a speak pipe@www.speakpipe.com whitecoatinvestor and if we get some good comments, we'll start mixing them into the episodes. And let me use this Mega Backdoor Roth topic to give an example of the kind of Speak Pipe commentary I would leave based on Megan's new invitation. So if I were a listener over the last couple years, there's one thing I've noticed as I've listened to Jim talk about the Mega Backdoor Roth steps and he kind of wonders out loud why people say Mega Backdoor Roth ira even though an IRA is rarely involved in this process, given that the strategy must always start in an employer provided retirement account like a 401k. So I always find it weird and mildly annoying that everyone says Mega Backdoor Roth ira. And my theory is that we as a financial community got so accustomed to saying Backdoor Roth IRA that when we add the Mega we can't help but saying Mega Backdoor Roth ira and the IRA at the end is just this compulsory habit that we can't seem to drop. So here's an example of what my Speak Pipe commentary might sound like taking Megan up on her offer for y' all to call in and and offer your two cents. Hi Jim, my name is Tyler. I'm a 41 year old former dentist and current financial nerd here in Salt Lake City calling with a comment regarding episode 402 where you address a question about the Mega Backdoor Roth ira. In the episode you wonder aloud why this technique is called the Mega Backdoor Roth IRA when it predominantly occurs in a 401 or 403 and rarely involves an IRA at all. I share that wonderment with you. Since we agree there is no formal or legal term known as Mega Backdoor Roth ira, I suggest that you, me and all of us stop using the term Mega Backdoor Roth IRA to universally describe this idea and simply say Mega Backdoor Roth. We can then use this term to describe the concept of moving after tax contributions immediately over to Roth accounts in order to max out our annual 415c limit in employer sponsored retirement accounts. From there we can say mega backdoor Roth 401 or mega backdoor Roth 403 for situations that allow in plan conversions. Or less commonly we can say Mega Backdoor Roth IRA Only when an IRA is actually involved via in service distributions. Thanks for all you do and thanks to the entire White Code team. Okay, that's my example of my Speak pipe comment and if this sounds appealing to you, send some in and we'll see if this can become a thing. Now let's connect all this back to Brian's comment. Based on what I just said, let's listen to Brian's Speak pipe again and ask yourself the question, does Brian know what he's talking about? Is Brian offering a thoughtful, correct, actionable comment here about the mechanics of the two options on how to make a Mega backdoor Roth? Let's publicly test Brian. Thanks Brian for being an unwitting experiment.
- [49:26]
Brian
This is a comment on the podcast that dropped Thursday, June 12. One of the questions was from a gentleman who was trying to figure out if his plan had an after tax option that could then be used to fund a mega backdoor Roth. Two questions that he should ask his benefits team or if the plan actually allows post tax contributions and if those contributions can be rolled into the Roth portion of the 401k. Another question to ask would be if the plan allows in service distributions. If it does not allow in plan conversions to the Roth portion. Some plans, mine included, do not allow direct conversions of after tax 401k money to the Roth option, but they do allow in service distributions. They can then be sent to an IRA and then converted to Roth from there. Hope that helps. Thanks.
- [50:25]
Tyler Scott
Okay friends, does Brian know what he's talking about? Did he describe the two mechanics of the mega backdoor Roth? Well, he did. He knows what he's talking about. He described the ways you can get money into the after tax bucket. First finding out if it's even an option and then once it's there you can do an in plan conversion or an in service distribution. So well done Brian. Thanks for your comment and let's see if we can get more of those from you guys. Okay, now some of you may be thinking at this point, what's the big deal about moving the after tax money to the Roth account anyway? Why not just leave it in the after tax bucket? That's a reasonable question. The answer is that if we leave the money in the after tax bucket, we will owe taxes on all the growth on the investments at ordinary income tax rates. And that's no fun. But if we move the money into the Roth sub account in the 401 or to our own Roth IRA. We don't owe any taxes on the growth of the investments. That's why it's really nice if you can work with your 401 provider to set up automated immediate transfers from the after tax subaccount to the Roth sub account. That way the after tax contributions are made each pay period and then immediately moved to the Roth account. This ensures all the growth on the investments is certain to happen in Roth land. Business owners like Jim with enough money like we talked about earlier can do it all at once. Just 70,000 deposited into the after tax account and immediately transferred to the Roth account. This isn't always possible. However, I have a client that's a physician at the University of Pittsburgh and her 401k which does allow the mega backdoor Roth. It only allows two transfers a year from her after tax account to the Roth sub account. This means she's contributing after tax dollars each pay period. Those dollars are experiencing some growth. Then she moves it all to the Roth account every six months and has to declare that growth as ordinary income. It's a bummer. It's a mild bummer for her because overall the access to the Mega Backdoor Roth far outweighs the small annoyance. But it's still, you know, not as good as it could be. The point is, don't leave the money in the after tax bucket longer than you have to and make the transfers automatic and or immediate if at all possible. Okay, let's tackle one more question for the for today's episode from Nick on this mega backdoor Roth topic. Nick, sorry, this question's from a long time ago and so I know that you're giving some 2024 contribution limits, but like something happened to the Speak pipe questions and we resurrected some old ones. So thanks for being patient with the response. Hi Dr. Daly, this is Nick. I'm an emergency physician, have a question about the Mega backdoor Roth. I'm 46, married, and because of a heavy clinical load and some side gigs, I make about 600,000 a year. I'm of the opinion right now as a high earner I should be doing traditional or pre tax contributions. Of the 600,000, about 90,000 is W2 income and that employer offers a 2.5% match. So I contribute 2,250 to a Schwab 401K to get the match there and they don't have the ability to take after tax contributions. So can't do a mega backdoor Roth in that account for the rest of my Income. I'm paid as an independent contractor and contribute to a cookie cutter solo 401k from fidelity. I max that out with 20,750 as an employee contribution and 46,000 as an employer contribution. As a high earner, I also put six figures into a taxable brokerage account and that account has grown to be bigger than our tax advantage savings. I understand the advantage of the Mega Backdoor Roth, but not sure I can do so as I think I have filled up already my 401 tax advantage space. And if there's a way to do a Mega Backdoor Roth, I would. And I appreciate your opinion on the matter. Thanks for all you do. Okay, friends, from what you've learned so far today, what would you say to Nick about his need or ability to do a Mega Backdoor Roth contribution? Think along with me here and let's see if we can solidify some of what we've learned and also try to give Nick some good advice. So Nick's 46. He makes $600,000. 90,000 of that is as a W2 employee at the hospital. And the other $510,000 is as a 1099 independent contractor. His W2 employer offers a 2.5% match in this Schwab 401K and he's contributing a little over $2,200. So his employer will put in $2,200 as well. He's making a smart choice here. So he doesn't leave $2,200 of free money on the table at the hospital. That's great. We also know that the Schwab 401 through the hospital does not allow for Mega Backdoor Roth. Then he's making another smart decision by having a solo 401k for his 1099 income. Let's pause here to test ourselves a little bit. What piece of information do you wish we had right now? When you hear, hey, I'm a self employed person and I'm about to ask a question that includes employer contributions to a solo 401. What are you desperate to know next? You want to know what kind of business entity he has set up? We wish we knew if Nick were operating as an LLC or an S Corp. Why? Because our employer contribution limit is very different for those entities. For an LLC, how much are the employer contributions? Very good. 20% of our net business profits. And if he were an S corp, how much can his employer contributions be? 25% of his W2 salary. Very good. In this case it doesn't matter because he told us he's maxing out the rest of his employee contribution in his Fidelity Solo 401 and making the full $46,000 employer contribution as well. He is doing this all pre tax, which is almost certainly the right thing to do given he is in his peak earnings years. And we've been recommending here for a long time on the podcast that that's almost always the right thing to do pre tax when you're in your peak earnings years. If you want to go down the rabbit hole on that, go listen to the other pre Tax vs. Roth podcast. Jim and Chris Davin talked about that at length. So whether he is an LLC with sufficient profits or his S Corp salary is high enough, we believe Nick when he says he's maxing out his fidelity solo 401k. I also realized I just said there a minute ago, that he's maxing out the rest of his employee contribution on the solo 401k side. Let's make sure we're all on the same page about that statement. Nick is not just asking a mega backdoor Roth question here. He's taking us into the world of multiple 401ks. And this is one of the areas most prone to mistaken advice in the personal finance field. This $70,000 415 limit we've been talking about this whole time is not per person. The limit is per unrelated employer. If you work for two different employers, you get two 415C limits, even if one of those two employers is yourself, as is the case with Nick. Now, that being said, the $23,500 employee elective deferral limit is per person. If you have five jobs, you don't get to put in 23,500 at each job. You need to divide up that 23,500 in such a way to maximize the match your employer offers at each of those five jobs. Notice Nick alluded to this in his question. He said he's putting in a little over 2,200 in his Schwab 401 at the hospital. And then he's putting in the rest of his employee elective deferral limit. Nearly 21,000 at his other employer, which is himself in his Fidelity Solo 401. Is that the right decision? I don't think so. I think Nick should consider making his entire 23,500 employee elective deferral limit at the hospital, assuming it's not a crappy plan with terrible fees and terrible investments. Why do I think that? Because he could then use the entire and separate $70,000 415c limit in his solo 401k, he said he's making 510,000 in 1099 money. So even with some business expenses, let's say his net business profits are 450,000. Well, if he's an LLC, he can put in the lesser of $70,000 or 20% of those profits in the solo 401k, all as employer contributions. Well, what's 20% of $450,000? It's 90 grand. That's more than enough to load up his solo 401 at Fidelity with the full 70,000 employer contribution to max out this separate 415C limit. And he's going to put another 23,500 in as an employee at the hospital 401K with Schwab. Plus he's going to get the hospital's 2.5% match. So that feels pretty cool. Go read Jim's post on multiple 401k rules for a better understanding of all of this. Well, that's not the question Nick asked. He asked about whether a Mega Backdoor Roth makes sense for him in his solo 401k. Well, friends at home, what do you think? Does the Mega Backdoor Roth have a role to play here? No, no it does not. Not in the solo 401k. Anyway. He makes enough in net business profits or has a high enough W2 salary from his S corp that he can get 70,000 in the solo 401k all as pre tax contributions. And that's awesome. No Mega Backdoor Roth needed. Where we wish we had a Mega Backdoor Roth is in the Schwab 401K at the hospital. If that plan had a Mega Backdoor Roth, we could max out that 415c limit as well. And Nick would be packing away 140 grand into his two 401s. This year he'd be doing about 98,000 pre tax and about 42,000 Roth. That would be pretty sweet. But alas, Nick has to live with the opportunity to only put away $98,000 pre tax and the rest of his investments need to go to his hsa, back to a Roth and his taxable account. Now nick, if your 1099 income ever drops to where you can't max out your 415c limit or you hit age 50 and that 415c limit gets a little higher due to catch up contributions, perhaps you will find the Mega Backdoor Roth useful to you in your solo 401k at that point, which you probably can't do it with that cookie cutter solo 401k you've got at Fidelity. You're going to want to go to our recommended list on the webpage. Scroll down, click on retirement accounts and HSAs. Scroll down from there to where you get to customized Solo 401K providers and for a few hundred bucks you can get a 401k that will let you do all the mega backdoor rothing you ever dreamed of. Okay, remember friends, don't just listen to talking heads like me and venture out there to do this on your own. Make sure to get your tax professional involved in all the minutiae and details and mechanics of all this. It actually can be pretty complicated. Okay, that's all the questions for today. Thanks for spending an hour with us and for your ongoing support. I really love you guys. I love this community. It is so fun to be a part of this. I'm so grateful to all of you who make it such a rewarding place for all of us to learn and grow together. So thanks for your questions, thanks for listening. Thanks for being part of this just beautiful group of people that we've created. If you like what you're hearing from any of us, probably more so from Jim. But if you, if you like anything you're listening to, please be open to leaving a five star review on Apple or wherever you listen. Today's five star review comes from Adam Henry and he described himself as Young Doc improving his financial wellness. Five stars. Incredibly important information for maintaining healthy financial lifestyle. Highly recommended. And even if you don't leave a review, we appreciate you sharing the podcast with friends, families, members and anyone who you think may benefit. All right, as I mentioned at the beginning of the podcast, SOFI can help medical residents like you save thousands of dollars with exclusive rates and flexible terms for refinancing your student loans. Visit sofi.comwhitecoatinvestor to see all the promotions and offers they've got waiting for you. One more time. That's sofi.com whitecoatinvestor SoFi student loans are originated by SOFI bank and a member FDIC additional terms and conditions appl 696891. All right, keep your head up, shoulders back. You got this. See you next time on the podcast. Have a great day, everybody. The hosts of the White Coat Investor are not licensed accountants, attorneys or financial advisors. This podcast is for your entertainment and information only. It should not be considered professional or personalized financial advice. You should consult the appropriate professional for specific advice relating to your situation.