The Mega Backdoor Roth
Overview: The Mega Backdoor Roth is a fantastic tool for supersavers. If one's 401(k) plan allows for after tax contributions, those contributions can then be rolled over to the Roth 401(k) inside the plan, or rolled out to a Roth IRA. This is great because then future gains and distributions are then tax free. With a 2019 401(k) contribution limit of $56,000, that leaves room for up to an additional $37,00 of after-tax contributions per year if you max out your $19,000 deferral limit. Having $37,000 per year of extra Roth space is an amazing retirement tool, but should only be utilized after fully maxing out other retirement accounts first, like the Roth IRA, 401(k) and HSA.
How does it work?
first coined the phrase Mega Backdoor Roth. It's a play on the term Backdoor Roth
, where a contribution is made, then a conversion is done to avoid further taxation. The Backdoor Roth involves using a Roth IRA where the Mega Backdoor Roth uses a 401(k), where larger amounts of money are involved.
Inside a 401(k), there are lots of different "buckets" of money. I want to focus on three:
The most common is a Traditional 401(k), where money is deferred
out of a paycheck prior to any taxation. This bucket grows tax free, but upon withdrawal, the money that was put in, plus any gains, are then taxed. Any employer match or non-elective contributions are also in the pre-tax bucket. Another common bucket is the Roth 401(k), where money goes in after tax and then grows and is withdrawn tax free. Both the Traditional and the Roth 401(k) buckets are limited to a total of $19,000, the 402(g) limit
In between these two common buckets, is the after-tax bucket. Specifically: the Non-Roth After-Tax portion. It's a hybrid of the Traditional and the Roth. Money goes in after tax like the Roth, but all gains are taxed like the Traditional. This is because in a 401(k), all gains outside of the Roth 401(k) are taxed upon withdrawal. So any gains that an after-tax contribution makes, will be taxed in retirement.
There is a simple solution to prevent any gains on after tax contributions from being taxed: Convert those contributions to either the Roth 401(k) or a Roth IRA. Doing so allows for any future gains to be sheltered from taxes on gains, just like any Roth account.
Numbers and Examples
For someone 49 or younger, the 2019 limit on 401(k) contributions is $56,000. The elective deferral limit, or what can be deferred
out of a paycheck, is $19,000. That leaves an extra $37,000 of investing space. Most employers offer either a match, a non-elective contribution, or both. Subtract off any of those employer contributions, and the remaining amount can be contributed into the "after tax bucket."
Let's say an investor maxes out her $19,000 deferral, gets a $2,500 employer match, and gets $10,000 from her employer in the form of a non-elective contribution. $56k - $19k - $2.5k - $10k = $24,500 remaining under the 401(k) limit. She could contribute ~ $2,000 a month in after tax contributions and stay under the cap.
Those $2,000 each month go in after tax, meaning she's already paid tax on those contributions. However, it will go in to the after tax bucket of her 401(k) meaning that any gains it makes will be taxed again upon withdrawal. If however, instead of leaving her $2,000 a month contribution sitting in the after tax bucket, she converted those contributions to her Roth 401(k) (called an in-plan conversion) or she rolled them out of her plan and into a Roth IRA, she would no longer pay tax on any gains. Doing this once a month or once a quarter means she would have very few gains on which to actually pay tax.
$2,000 a month at 8% is $3 million dollars after 30 years, or $1.7 million real dollars in today's money after 3% inflation. Subtract $720,000 of contributions, and that's a lot of gains to pay tax on! If she converted her $2,000 per month to her Roth 401(k) each month, she might pay taxes on a few dollars of gains, but that's it. The rest grows tax free. Hence: the Mega Backdoor Roth.
What's the catch?
There's always a catch, isn't there? The biggest catch is that many people's 401(k) plan simply do not offer after tax contributions. The custodians of 401(k) plans, like Vanguard and Fidelity, keep track of the basis and all the taxable vs non-taxable gains, so employers could offer an after tax plan if they wished. However, many apparently don't. Step one in getting the Mega Backdoor Roth is to simply ask for an after tax option. Step two is to have in-plan conversions, but many plans have that already. The third and final step is to actually have both the income and the discipline to save above and beyond normal contribution limits.
This isn't for people who haven't already maxed out their other retirement accounts. Always max out the 401(k), max out a Roth IRA and a spousal Roth IRA, max out an HSA, and be saving in a brokerage account to offset Traditional 401(k) contributions
prior to contributing any after tax funds to a 401(k). After tax money is great, but only after you've reaped tax deferrals through normal contribution channels.
Some better writers than me have tackled this topic:
I am fortunate enough that my employer offers after tax contributions. It's easier than it sounds (just a few clicks inside your 401(k) and you're all set). If your employer offers it as well and you get stuck or have questions, feel free to shoot me a PM. Like I tell my co-workers: "Contribute then Convert." Contribute your after tax money, then convert it to Roth for tax free gains from then until eternity.
There are those who like tax free Roth money because they are worried the government will change the income tax laws, so they want their taxes paid now. Others like the tax deferred Traditional money because they are worried that the government will change the income tax laws so they want their taxes paid later. See what I did there? In other words, there are always guesses and theories as to what tax rates will do. My advice is to plan and make decisions based on today's
tax law, and then adapt if it ever changes.
The government likes Traditional investments because it gets more taxes from them, but at a later date. The government likes Roth money because it gets its taxes up front, today. I don't see either style going away. The correct answer to Roth or Traditional? Both.