What Is a Mega Backdoor Roth?
A mega backdoor Roth is a technique that allows investors who earn too much to get around these restrictions to be able to make contributions to a Roth account.
As background, a Roth IRA is an IRA where after-tax contributions are made as opposed to the pre-tax contributions made into a traditional IRA. Your contributions grow tax free. The real tax benefit of a Roth is the ability to withdraw your money tax-free at retirement or in some other cases as long as certain requirements are met. Roth IRAs are not subject to required minimum distributions (RMD), making them an excellent estate-planning tool.
Some of these requirements include:
- The five-year rule. If you have had a Roth IRA account open for at least five years, then you can withdraw funds tax-free at age 59½ or older.
- You can with draw funds tax-free prior to that under certain circumstances.
Contributions to a Roth IRA are dependent upon your income and if you earn too much you are prohibited from contributing to a Roth IRA.
A backdoor Roth is a means for investors who earn too much to use a "backdoor" method to contribute to a Roth IRA. This generally involves making an after-tax contribution to a traditional IRA account, then converting some or all of the money in the account to a Roth IRA.
This conversion may or may not be taxable, all or in part, depending upon the mix of pre- and post-tax dollars in the account. The annual IRA contributions are limited to $6,000, and $7,000 for those who are over 50 for 2019. There is no change to these limits for 2020.
A mega backdoor Roth takes this even further. A mega backdoor Roth offers the opportunity for some investors to contribute up to an extra $37,000 for 2019 to a Roth IRA via their employer's 401(k), if the 401(k) allows for after-tax contributions over and above the employee contribution limits. These limits are $19,000 for 2019 and $25,000 for those who are 50 or over. The limits for 2020 will be $19,500 and $26,000, respectively.
How Does a Mega Backdoor Roth Work?
A mega backdoor Roth requires that your employer's 401(k) have a couple of attributes:
- Your company's plan must allow you to make after-tax contributions.
- The plan must allow in-service withdrawals.
If your plan allows after-tax contributions, these contributions would be over and above the employee deferral limits. For 2019, the total amount of combined employee and employer contributions allowed is $56,000 and $62,000 for those 50 and over. For 2020 these limits are $57,000 and $63,500. This means that the maximum amount of after-tax contributions are $37,000 for 2019 and $37,500 for 2020. If your plan offers an employer match, your maximum after-tax contribution would be reduced by the amount of the match.
The mega backdoor Roth works best if your plan offers in-service withdrawals without restrictions. This feature allows participants to roll their balance over or withdraw some or all of balance while still an employee of the company.
If your plan allows both after-tax contributions and in-service withdrawals, here are the steps that you will need to take:
- You will need to figure the maximum amount of after-tax contributions that you can make and ensure those contributions are made to a traditional account on an after-tax basis, not to a Roth 401(k) option within the plan.
- Once you have made the maximum after-tax contribution, you will want to withdraw this amount as a rollover/conversion to a Roth IRA account. The conversion will not be taxable unless there are earnings on this amount. These earnings will be considered pre-tax and subject to taxation.
The number of plans that offer both the ability to make after-tax contributions and do early withdrawals without restrictions is relatively small.
In some cases, a plan might allow in-service withdrawals for employees who reach a specified age, perhaps age 55 or age 59½. This can still be a good alternative, though the earnings on the after-tax contributions might add up depending upon how long you've been making the after-tax contributions.
As an alternative, if your plan doesn't allow for in-service withdrawals, you can allow these after-tax contributions to accumulate until you leave the company. The earnings attributed to these contributions will likely add up to a more significant amount adding to the taxable portion upon rollover/conversion to a Roth IRA account. This works especially well if you are planning to leave the company in the near future.
Another alternative method if your plan doesn't allow in-service withdrawals would be an in-plan conversion to a Roth 401(k) account if your plan offers this option. Again, your plan would need to offer this conversion option as well. With a Roth 401(k) you have most of the same advantages as a Roth IRA, however you will want to be sure to roll this portion of your 401(k) over to a Roth IRA when you leave the company.
One other possibility exits for those who are self-employed. If you contribute to a solo 401(k) you may be able to do this, depending upon the rules of your plan. Most standard custodians likely won't allow for these additional after-tax contributions, but via a self-directed IRA custodian you may be able to set a plan that allows for this.
Who Should Consider a Mega Backdoor Roth IRA?
A mega backdoor Roth IRA is a great tool for those who are looking to save additional amounts for retirement and whose 401(k) plan is set up to allow them to do this.
This tactic should be considered after you've maxed out other tax-deferred savings vehicles such as:
- Employee contributions to your 401(k).
- Contributions to an IRA in the most appropriate format for your situation.
- An HSA account if you have access to a high-deductible health insurance plan that meets the criteria.
- A 529 or other college savings plan if you have children.
Overall, those who are looking to contribute larger amounts to their retirement accounts and who want to build up a significant balance within a Roth IRA should consider this method if it's available to them.