Blog: How Does A Mega Backdoor Roth Work?

mega backdoor roth

A Mega backdoor Roth is a retirement savings strategy that could allow you to put up to $38,500 in a Roth 401(k), on top of your regular $19,500 annual contribution. There are many moving pieces that all need to fall into place in order for this strategy to work, so we highly recommend you consult a financial advisor before trying this method. Don’t let this scare you away though, since the benefits of a mega backdoor Roth are huge. If done correctly, it can potentially save you tens of thousands in taxes.

Review of 401(k) basics

Before we get into the details of a mega backdoor Roth, let’s start with some background. Many people have access to a 401(k) retirement plan. This is a plan offered through an employer and allows employees to save either pre-tax (traditional) or post-tax (Roth) money out of their paychecks each month. Many employers also offer a matching contribution to their employee’s 401(k) accounts. 401(k) accounts have limits on what the employee can add, and the total that can be contributed to the account during each tax year. 

With a 401(k), the employee can add up to $19,500 (under age 50) and $26,000 (over age 50) into their 401(k) account either on a traditional or Roth basis. On top of that, the employer can add a matching or flat contribution to the employee’s account. Pre-tax or traditional contributions are tax deductible now, and then taxable when funds are withdrawn during retirement. Many employers, but not all, offer the Roth 401(k) option in which the employee’s contributions can be made with post-tax money, and then grow tax free. The employer match will always be traditional money and will grow tax-deferred, and taxes will be paid on those funds when they are withdrawn in retirement. 


What is a Backdoor Roth?

Now that we have discussed the 401(k) basics, let’s talk about what the typical “Backdoor Roth” means. A Backdoor Roth IRA is a strategy used by those with income too high to contribute directly to a Roth IRA. In this instance, one would contribute to a non-deductible traditional IRA and then convert that money to a Roth IRA to allow it to grow tax free. 

As long as there is no other money sitting in a traditional IRA that was deducted on prior tax returns, the conversion does not generally trigger a taxable event, because the money being converted was not deductible. Take a look at our blog on how to do a Backdoor Roth for a step-by-step guide. 

 

What is a Mega Backdoor Roth?

So where does the term “Mega” come in? A mega backdoor Roth can allow up to around six times the amount you can do in a regular backdoor Roth IRA. While a backdoor Roth IRA can typically result in $6,000 of money to grow tax free, a mega backdoor Roth can potentially result in $38,500 of money to eventually grow tax free. That’s a lot of potential tax-free money, hence the term “mega.” 

A mega backdoor Roth is done through your 401(k). In addition to your traditional or Roth 401(k) contributions (limit of $19,5000 or $26,000 over age 50), some 401(k) plans allow you to contribute to a third type of account: “after-tax” contributions. Up to $38,500 in additional “after-tax” contributions can be made (if your employer is not providing a match; less than this if so). After-tax contributions are not tax-deductible, nor is it a Roth. 

A key part of this strategy is being able to convert these after-tax 401(k) contributions to Roth. If you convert these after-tax dollars into a Roth account, you are then taking advantage of being able to grow even more tax-free money for retirement than you otherwise could. This can allow high-income earners to not only max out their Roth 401(k) and their backdoor Roth IRA, but also add significantly more to their 401(k) to potentially grow tax free. 

In order for this strategy to work, two things need to be in place. 

First, your employer must first offer the ability to add “after-tax” contributions into the 401(k) plan. This is different from Roth 401(k) contributions. Only a handful of employers offer after-tax contributions, most of the big companies like Google, Facebook, Adobe, or AT&T.

Second, the employer plan must also allow one of two things. The plan needs to allow an “in-plan Roth conversion,” where the employee’s after-tax contributions are rolled into the current Roth portion of the plan (essentially converting it to a Roth 401(k)). Or it needs to allow the employee to roll these funds out of the plan into a Roth IRA, even while still an active employee. If the employer offers after-tax contributions but does not allow one of these two options, the mega backdoor strategy may not work. 

To find out more about mega backdoor Roth, visit https://districtcapitalmanagement.com/mega-backdoor-roth/

MCM disclaimer for blogger content

Write a Comment

Related Articles