Backdoor & Mega Backdoor IRAs for your early retirement plan (FIRE)
Is there a way that I can save some money in taxes? Yes, you can with Backdoor & Mega Backdoor.
My goal is FIRE (Financial Independence, Retire Early), and I really hope to retire early and travel the world and become a surf bum (just kidding). To maximize my chance of financial freedom, I have to start thinking about saving money from taxes.
I have to pay approximately 50% in taxes out of my monthly paycheck. Then, if I invest that money in the stock market, another sales tax is applied when I sell my stocks.
We all love Uncle Sam #amirite (am I right?)
Is there a way that I can save some of that money? If billionaires pay almost no taxes, can I at least save some?
Backdoor and MEGA Backdoor IRAs are some of the tools you can use to save taxes for your retirement.
What are the Retirement Accounts?
If you know what they are, skip this part.
Before we dive into what Backdoor and Mega Backdoor are, let’s get familiar with IRAs.
IRA stands for Individual retirement account, an account set up at a financial institution that allows an individual to save for retirement on a tax-free or tax-deferred (you pay tax later) basis. There are two types of IRA.
Traditional IRA is an IRA in which you pay taxes when you retire. If you contribute $100 from your paycheck, it will go directly to your IRA in full and will be distributed to the investments. The downside is that you will have to pay tax when you take the money out. Let’s say your investment becomes $200, you will pay tax on $200 based on your income level at your retirement age. Please read more about it here for important details or google it.
Roth IRA is an IRA in which you pay taxes upfront. If you contribute $100 from your paycheck, it will deduct taxes from $100 and will be distributed to the investments. The growth will be slower because taxes are deducted from your contribution. However, the investments will grow tax-free and if you reach retirement age, you can withdraw your money tax-free. Please read more about it here or, again, google it.
Backdoor Roth IRA is an informal name for a complicated method used by high-income taxpayers to create a permanently tax-free Roth IRA, even if their incomes exceed the limits that the tax law prescribes for regular Roth ownership. Read more about it here.
Mega backdoor Roth IRA conversion is for people who have a 401(k) plan at work; they can put up to $40,500 of post-tax dollars in 2022 into their 401(k) plan and then roll it into a mega backdoor Roth, which is either a Roth IRA or Roth 401(k). More information here.
How did I set up?
I have employer-sponsored retirement plans with Fidelity Investments so I called them to set up my Backdoor and Mega Backdoor.
The representatives from different departments (401k, IRAs, Workplace, etc) helped me with setting up Backdoor and Mega Backdoor IRAs. For Mega Backdoor, it won’t be possible if your company does not allow automatic after-tax Roth conversion. I think it’s an additional feature that your employer has to pay for. However, you can do Roth conversion when you leave your current employer and roll over your Roth and after-tax 401(k) to Roth IRA.
There can be some tax implications so consult with your tax accountant if you’d like. I’m planning to see the tax accountant since this is my first time setting them up.
It took about 3 hours for me to make phone calls to Fidelity to set up my IRAs with Backdoor and Mega Backdoor. Now I know why wealthy individuals have financial advisors to manage their finances because it does take a lot of effort to understand and navigate the financial system and its loopholes. I wish I knew about Backdoor and Mega Backdoor earlier in life but I’m very glad that I set them up now for my future!
I hope you find this article useful and save your fortune from Uncle Sam! Wish you the best of luck with your FIRE journey.
P.S: If you like this article, it won’t hurt to hit follow 😉.
Live life to the fullest,
Stephen Sungsoo Lee