In today’s tax and investment environment, a Roth IRA is a great account to consider. Once in a Roth, funds grow tax-free, withdrawals are tax-free, and there are no required minimum distributions to take.
I’m always looking for ways to get people to fund a Roth IRA.
So if you like the idea of a Roth IRA in the first place, then you will definitely like this supersized version: THE MEGA BACKDOOR ROTH. This hidden 401k strategy takes things to a whole new level.
What is the mega backdoor Roth IRA strategy?
The structure itself is pretty straightforward. The “mega backdoor” Roth IRA strategy is where you would contribute indirectly to a Roth IRA via your 401k. You may be aware that if you exceed certain income limits, you will be unable to contribute to a Roth IRA account directly. So this is a way around it (and yes, it’s legal).
The mega backdoor IRA could be made possible if your retirement plan allows for after-tax contributions and simultaneously allows in-service distributions. These are two components of a 401k plan that most people do not know about unless you take the time to read the plan documents (or hire an advisor like me to do it for you).
If the above two components are allowed, then you should be able to transfer large chunks of your 401k to Roth IRAs. In other words, investors would be allowed to direct more assets into a Roth than they otherwise would.
Isn’t this the same as my Roth 401k option?
This is a question I get a lot, and it is sometimes confusing. While a Roth 401k option does involve after-tax dollars, there are a few key differences.
First, if your plan offers a Roth 401k option (around 2 out of 3 do) they may or may not allow a “non-Roth, after-tax” option. All 401k plans allow “pre-tax” contributions, and some allow Roth option and some allow after-tax options as well. Sometimes a plan will offer all three – which are distinctly different – sometimes just one or two of those options are available.
Second, Roth 401k contributions are subject to the contribution limits of $19,500 in 2020 (or $26k if over age 50). If using after-tax contributions, the total annual 401k contribution can be as high as $57k (or $63,500 for age 50+). This comes in super handy if you want to continue saving over and above the traditional limits.
Last, by executing the backdoor strategy – you have a much wider array of investment options to choose from. Not just the limited “menu” of choices of the 401k provider.
What if my 401k does not allow this (or I don’t have one)?
Either your employer plan allows after-tax contributions or it doesn’t. If it does not allow after-tax contributions, and/or in-service withdrawals, then we might as well remove the word “mega” from the opportunity. You can even request that they start to allow them, the plan documents can always be updated.
That said, you may still have these alternatives:
- If you are under the income limits, contribute to a Roth IRA directly.
- If you are over the income limits, do a regular backdoor Roth IRA. Tax rules make this option a little more complex.
- Another option, if your plan rules allow for it, is to make straight after-tax contributions to your Roth 401k. More and more companies are making this an option these days.
- Your retirement plan may allow you to make in-plan Roth conversions (right there, within the 401k plan).
- Make after-tax contributions even if your plan disallows in-service distributions, and when you leave the company – roll the funds into a Roth at that time.
OK, my plan allows it! What are the steps to executing this strategy?
Once it’s been determined that your 401(k) allows for the mega backdoor Roth IRA (and you can make in-service withdrawals at your age), it’s time to allocate a certain percentage into it. Each situation is unique and has a different comfort zone, so there is no right or wrong here.
In 2020 the maximum contribution one can make $57,000 (more if over age 50), minus your other employee and employer contributions. Theoretically, it means that you could contribute up to $37,500 per annum which is after subtracting the $19,500 employee contribution.
Often, for a significant number of people, the maximum contribution will be lower since the employer will likely contribute money to your 401(k) as well. So, whatever amount the employer contribution will also have to be deducted.
For example, say you’re age 40, earn $100,000, and you’re contributing 20% of your pay in your pre-tax 401k. In 2020, your contributions get capped at $19,500. On top of that, your employer matches your contributions dollar for dollar, up to 3% of your salary. That means they add $3,000 this year. The maximum amount you can put in the after-tax portion of your plan this year is $57,000 minus $19,500 minus $3,000, which is $34,500.
The next step is to take the in-service distribution, which essentially is the “conversion” part. You have the 401k account send out the after-tax money, and you make sure it gets deposited into the Roth IRA. The plan may limit the number of times you can do these distributions (twice a year is common). But mark your calendar to take this action item regularly.
Are there any downsides?
Besides limiting the number of times you can do this per year, sometimes the 401k you require you to call them each time (versus doing it online). Your employer will often send the checks to your home address, and then you have to send them to the Roth IRA. So it’s a multi-step process.
Keep in mind, your contributions will be tax-free during the rollover, but your earnings will be taxed. Since you’re converting regularly, your gains will be minimal, and therefore the taxes will also be minimal. And once the rollover is complete, all of your contributions plus the returns on them will grow tax-free and will be tax-free even upon retirement. But there are some tax nuances to navigate, including how to treat any “gains” that may have accumulated.
It’s important to let your 401k plan administrator understand your intentions to avoid any unintended consequences. And the specific mechanics of doing so differ by 401k provider, so be sure to follow the appropriate steps. Powerful strategies like this require care and attention to detail.
Conclusion on the Mega Backdoor Roth IRA
I love efficient tax structures! That’s why the so-called Mega Backdoor Roth IRA strategy happens to be one of my personal favorites. It’s a great retirement strategy because, in essence, it turns your after-tax contributions into Roth contributions.
Provided that your 401k and IRA providers allow for this, it can be an unbelievable way to sock away significant money that will be completely tax-free upon retirement. Using the example from above, let’s assume you can afford to save half of your income (it can be done!). Here’s what it would look like:
If you are unable to pull it off now – don’t lose sleep over it. There are some nuances and maybe you aren’t in a position to save a large portion of your income. Nevertheless, it may become an option for you in the coming years. And if you are already saving in other ways, you are still ahead of the game!
Are you going to try a mega backdoor Roth IRA? We’d love to hear from you if you are trying it or otherwise have questions about it. It’s always advisable to work through this process with a professional.
This blog and the information provided on this website to readers (aka the “users”) have been issued by TrustTree Financial, LLC (“TTF”). It has been prepared solely for informational purposes and should not be construed as an offer to transact in any tax strategy without first consulting with their tax or financial professional. The contents are based upon or derived from, information generally believed to be reliable although no representation is made that it is accurate or complete. TTF accepts no liability with regard to the user’s reliance on it. The information contained herein is a summary of any transaction described and is incomplete and provided for the convenience of the user and is subject to change without notice. The information contained herein is not intended to be a source of advice with respect to the material presented, and the information does not constitute investment advice. Accordingly, any decision in regards to strategies mentioned herein must be made solely on the information contained from a trained professional and no reliance is to be placed on any other representations.