By Matthew Stratman
Are you a highly compensated individual looking to get more money into your Roth accounts? Perhaps you are looking for a strategy to turbo-charge your retirement savings. With the contribution caps on 401(k)s and IRAs many supersavers may feel they are not able to contribute as much as ideal. What can you do if you want to put more money into a Roth? A mega-backdoor Roth may be the little-known secret you are looking for.
What is a Mega-Backdoor Roth Contribution?
This is a multi-step strategy that can enable you to contribute significantly more to your Roth accounts on an annual basis. In addition to your regular 401(k) contributions and your employer contributions, some plans will allow for an additional after-tax bucket that you can contribute to. This after-tax bucket is separate from your regular 401(k) contributions. After you contribute to the after-tax bucket you can convert the balance to a Roth IRA or transfer to your Roth 401(k), giving your money the ability to grow tax free. While an after-tax contribution will not provide immediate tax benefits, converting to a Roth can ultimately be a tremendous advantage over an extended period.
The IRS limits on total 401(k) contributions is $57,000 in 2020. Therefore, if your 401(k) allows for voluntary after-tax contributions you would subtract your regular 401(k) contribution along with your employer’s match (if you receive a match). The amount left over is how much you will be able to contribute to your after-tax bucket.
How do you qualify and what are the steps for this type of contribution?
1. If you are considering a mega-backdoor Roth, you first should be maxing out your 401(k) and IRA contributions. In 2020 an employee can contribute up to $19,500 to their 401(k). If you are over the age of 50, you can contribute an additional $6,500 as a catch-up contribution. IRA limits are $6,000, and $7,000 if you are age 50 or older.
2. The next important factor is you need to have a 401(k) plan that allows for after-tax voluntary contributions. If you are not sure your plan allows this type of contribution, check with your plan administrator or human resource manager. Once you have made the after-tax contribution the money can be invested and begin growing.
3. Invest the money for at least a year and then convert to a Roth account. By allowing some passage of time prior to converting you will avoid the risk of having the IRS view this as a single transaction. If this is done too quickly and they view it as a single transaction, they can impose a 6% excise tax.
If your 401(k) allows in-service distributions, you would be able to rollover this balance to a Roth IRA. If your plan does not allow in-service distributions, you would only be able to do an in-plan conversion and move this money to your Roth 401(k) bucket. If given the choice, it may be more beneficial to roll over the account to your Roth IRA. There are more favorable withdrawal rules with Roth IRAs. The IRS allows Roth contributions, but not the growth, to be withdrawn penalty free after 5 years. Therefore, the contributions could be used as an emergency fund if needed.
When you convert after-tax balances to a Roth, no taxes would be due on the conversion of your contributions. The earnings associated with those contributions are considered pretax contributions and subject to taxes if converting to a Roth.
When completing a rollover from the after-tax account you cannot selectively leave behind the earnings to avoid paying taxes. However, the IRS does allow you to split the rollover between a Roth and traditional IRA. This means that you can send the pretax portion of the distribution (the earnings) to a traditional IRA and the after-tax portion to a Roth IRA, resulting in a tax-free rollover and conversion.
Once the money is in a Roth all withdrawals will be tax-free once you reach the age of 59 ½. There are no required minimum distributions like there would be for traditional IRAs. For that reason, the money can stay invested, continue growing, and ultimately be used as a tax-free death benefit for your beneficiary.
Here is an example of how this can work in practice:
Maria, age 45, is a doctor who earns $400,000 a year and contributes the maximum to her 401(k). Maria determines that her pension, Social Security, and ample savings will be more than enough to maintain her lifestyle while in retirement. However, she does not like the idea of being forced into taking required minimum distributions in the future. Maria would rather put as much into her Roth as possible.
Maria checks with her plan administrator and they do allow after-tax contributions and in-service distributions. In 2020 Maria contributes $19,500 to her 401(k), and $6,000 to a non-deductible IRA. Her employer matches 100% of her contribution up to a 3% salary deferral which equals $12,000. That leaves an additional $24,500 that can be contributed to an after-tax bucket. This is calculated by taking the maximum 401(k) contribution of $57,000 and subtracting Maria’s contribution and her employer’s contribution.
The funds within the after-tax bucket and IRA get invested and after a year she decides to convert both amounts to her Roth IRA. Due to the positive returns of the investments the after-tax bucket has $1,000 in growth and the non-deductible IRA has $500 in growth. When funds are rolled over and converted to a Roth IRA the growth is treated as a pretax contribution and will be subject to taxes for that year. By converting her after-tax contribution along with the non-deductible IRA, Maria can put an additional $30,000 a year into her Roth IRA. This process can be repeated year after year to ultimately build a substantially larger Roth IRA.
Some additional notes:
Your 401(k) needs to pass non-discrimination testing every year to ensure that your plan does not offer substantially larger benefits to high-income employees than to lower-paid employees. This testing can limit the amount of after-tax contributions that high-paid employees can make and possibly force your 401(k) to return your contribution to you if it does not pass the non-discrimination test. High-paid employees are often the only participants able to afford after-tax contributions. That is why this type of contribution may work best on small plans with only high paid participants or solo-401(k)s. A solo-401(k) is a plan for self-employed persons with no employees (other than a spouse). Solo-401(k)s are not subject to IRS non-discrimination rules.
If you are considering a mega-backdoor Roth conversion it is important to view this in the context of your overall financial strategy. Analyze all your employee benefits including HSAs, stock options, and nonqualified deferred compensation with tax projections for how they all work together. A thoughtful approach is necessary when projecting retirement income and tax concerns many years into the future. An experienced financial planner can help navigate the complex rules to ensure the conversion is done properly and for the right reasons.
About the author: Matt Stratman
Matt Stratman is a financial adviser at Western International Securities. His focus is helping business owners and entrepreneurs who are planning for retirement. With a strong client-centered approach, he creates personalized investment strategies to help them reach their financial goals.
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