Little-Known Tactic Lets Retirement Savings Grow Tax-Free
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Here's your Money Briefing for Friday, July 16th. I'm J.R. Whelan for The Wall Street Journal. The founder of PayPal, Peter Thiel, recently caught the attention of a lot of retirement account holders when it was reported he'd amassed $5 billion in his Roth IRA account using a little-known technique. That got a lot of people wondering, how can I jumpstart my retirement savings?
Anybody can do it if you have the disposable income. You have to have the savings somewhere. But if you do, it's a great way to move your savings from what might be growing as a taxable account into your Roth IRA via that route.
So how do Roth IRAs work and what are the advantages? Coming up, we'll talk with CPA and IRA specialist Ed Slott about it and about the backdoor trick to get around contribution limits. That's after the break.
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Millions of Americans make contributions to their Roth IRA retirement account each year so that the money will be available later in life. But a quirky rule that not too many people know about allows those account holders to make annual contributions above what's normally allowed by the government. It's called a mega backdoor Roth conversion. It can get complicated, but it can also pay off. So to walk us through it, let's bring in CPA and IRA specialist Ed Slott. Ed, thanks for being with us.
Great to be with you. Thanks.
So, Ed, let's start with the basics. Can you help us understand what the difference is between a Roth IRA and a 401k?
What news about Peter Thiel sparked interest in Roth IRAs and mega backdoor conversions?
A Roth IRA is your own personal retirement account. That's why they call it individual retirement account. And you also can have a traditional IRA. Each of those are versions of your own personal retirement accounts. The difference is tax wise. With a traditional IRA, you can get a tax deduction for your contributions, but then when you distribute in retirement, the funds you take out will generally be taxable. As opposed to a Roth IRA, where you do not receive a tax deduction, but the big benefit on the back end, if you qualify, you hold the account for five years and you're 59 1⁄2 years old, for the intended purpose to use in retirement, then all distributions in retirement should be tax-free to you out of your Roth IRA.
So that's the big tax difference benefit of the Roth IRA. A 401k is not your own personal retirement account. It's actually maintained by a company you may work for, that sponsors a 401k, a retirement plan for all the employees, which you may be able to partake in. But it's housed, it's maintained by the company.
Okay, got it. So people can build savings tax-free over time in their Roth IRA. But then there's an option we're talking about today called a mega backdoor Roth IRA conversion, and it involves money that's in an after-tax version of a 401k. Can you explain that?
So let's say you put in, I don't know, another $30,000 in the after-tax account, and the company allows in-service withdrawals, which means you're allowed to take the money out of the after-tax account at any age, even though you're still working there.
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