Author: Service2Client

The Roth IRA is a retirement savings account in which you invest only after-tax dollars. Subsequently, all earnings grow tax-free and may be withdrawn tax-free. However, there are limits to who can contribute and how much they can contribute to a Roth IRA.

Federal rules restrict direct contributions to a Roth IRA for high-income earners. In 2023, a single, head of household, or married, filing separately tax filer may contribute up to $6,500 if under age 50; $7,500 if 50 or older. However, if the investor has a modified adjusted gross income (MAGI) above $138,000, he is permitted only limited and phased out contributions up to a total annual income of $153,000, above which he cannot contribute to a Roth. Limited contributions for an investor who is married and filing jointly begin at $218,000 in annual income and phase out at $228,000.

However, there is a way to work around these contribution rules using a Roth IRA conversion. To optimize this strategy, investors may be able to conduct a Mega Backdoor conversion from their employer-sponsored retirement plan to a Roth.

The Mega Backdoor Roth strategy is suitable in a handful of circumstances:

• When you’ll be able to max out your employer plan contribution
• When your earned income is too high to contribute to a separate Roth IRA
• If you can save more than the 401(k) and IRA combined limits in one year

Employer Rules

To deploy this strategy, the investor must check with his retirement plan administrator to ensure that the plan allows for post-tax contributions and in-service distributions. If so, the investor should first max out his income-deferred contributions to the 401(k). In 2023, the maximum 401(k) contribution limit is $22,500, $30,000 if age 50 and older.

However, he may invest a maximum of $66,000 or $73,500 (age 50 and up) in his 401(k) for the year, which is the combined total for employer and employee contributions. For example, let’s say a 52-year-old employee earns $200,000 and defers 15 percent ($30,000) of his pre-tax income. His employer kicks in another dollar-for-dollar match of up to 4 percent of his salary ($8,000). With the deferred total at $38,000, the employee could pitch in another $28,000 in post-tax contributions to his after-tax 401(k) account – to reach the maximum total of $66,000.

The next step is for the employee to take advantage of in-service distributions by immediately rolling over his contributions from the 401(k) to an in-plan Roth option or a separate Roth IRA – before any earnings accrue (to avoid taxes on earnings).

Tax Notes

Once the after-tax funds are converted to the Roth IRA, the money grows tax-free, and the investor can withdraw it as tax-free income in retirement. There also is no RMD requirement for Roth IRA funds at any age. However, note that if the funds are converted to an in-plan Roth option, earnings are subject to a penalty if withdrawn before age 59½. If the funds are converted to a separate Roth IRA, tax-free withdrawals are only available penalty-free for five years after each corresponding rollover is conducted.

The Mega Backdoor Roth strategy is appropriate for high earners looking to minimize taxes on both their current income and their long-term retirement investments.

The College Savings 529 plan offers a way for modest-income families to save and invest for college expenses for their children as early as birth up to college age. When invested 529 funds are used to pay for the beneficiary’s qualifying education costs, earnings are distributed tax-free.

However, a lesser-known advantage for wealthier families is that the 529 plan can be used as an effective tax-advantaged tool for funding college expenses for family members over multiple generations. Basically, the 529 enables the investment to continue growing tax-free for years and even decades after the death of the original owner and beneficiary.

Assets from a 529 account may be used to pay for expenses associated with higher education, including tuition, fees, books, room, and board. The 529 also can be used to pay up to $10,000 a year in tuition expenses for K-12 education and a lifetime total of up to $10,000 in student loan repayments.

No Age or Use Restrictions

The two key components to this planning strategy, referred to a Family Dynasty 529 plan, are that the beneficiary can be changed at any time and that there is no time frame during which all assets must be distributed (including no required minimum distributions).

Note that the selection of a 529 beneficiary is rather broad:

•        Account owner (self)
•        Spouse
•        Child
•        Spouse of a child
•        Brother, sister, stepbrother, stepsister or their spouse
•        Mother, father, the ancestor of either or their spouse
•        Stepfather, stepmother or the spouse of either such person
•        Nephew, niece or their spouse
•        Aunt, uncle or their spouse
•        Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, sister-in-law or their spouse
•        First cousin

While the 529 can have only one named beneficiary at a time, the beneficiary can be changed at any time (such as once a student graduates), leaving the remaining funds for the next beneficiary.

No Contribution Limit

Unlike federal tax filings, many states offer a limited tax deduction on annual 529 contributions. Note that there is no limit to the amount that can be contributed to a 529 account each year. However, there is a limit to how much can be contributed to each 529 account in total, and that amount differs by state, with the range falling between $235,000 and $529,000. Georgia and Mississippi are the lowest at $235,000, and California features the highest limit at $529,000 (note that a California account can be opened no matter where the owner or beneficiary lives). Moreover, there is no limit to how much invested tax-free 529 assets can grow.

One strategy is to fund a family dynasty 529 with the maximum limit in one lump sum. The idea here is that one lump sum invested for tax-free growth offers the potential to fund college education expenses for a vast number of extended family members over several generations. Each time a beneficiary graduates, a new beneficiary is named. If there are multiple students scheduled to attend college at the same time, multiple 529 accounts can be opened with separate beneficiaries.

Changing Owner for Dynasty Plan to Continue

It is likely that when funding over several generations, the original 529 account owner will pass away. A few plans permit change of ownership only in the event of the death or incapacity of the current owner, but most 529 plans allow the change in ownership at any time, as long as the owner has reached the age of majority for that state’s plan. By periodically changing both owners and beneficiaries of the account, the family dynasty 529 can continue to grow and pay for qualified education expenses indefinitely.

The 529 also may be structured so that the account owner is a trust, which makes it unnecessary to change owners as they pass away. A trust can help protect 529 funds from creditors and may contain language mandating that assets can be used only for higher education – thus eliminating the potential for a beneficiary to drain the account with non-qualified withdrawals.

Potential Gift/GST Tax Consequences

Be aware that some state 529 plans may treat a change in ownership as a distributable event and will issue Form 1099 for tax purposes. Also note that when a new 529 plan beneficiary is one or more generations below the most recent beneficiary, distributed assets beyond the annual gift tax exemption ($17,000 for 2023) may be subject to the gift tax. In this scenario, should excess amounts exceed the lifetime gift tax exemption ($12.92 million for 2023), distributions may be subject to an additional generation-skipping transfer tax (GST).

The Family Dynasty 529 plan is best optimized when started early, such as the birth of the first child, and overfunded to the maximum limit. This allows for the best growth opportunity, wherein college expenses may be funded using tax-free earnings, leaving the principal available to grow for the next student beneficiary. Better yet, parents or grandparents can retain control of the account to ensure it is used only for college funding over multiple generations.