Unpacking the Mega Backdoor Roth IRA

retirement planning | Taxes & Tax Planning

 Daniel Lee By: Daniel Lee

Admittedly, the “mega backdoor Roth IRA” is a mouthful of a term. I wonder who came up with it? It’s as if they took their cue from Barnum & Bailey’s Greatest Show on Earth.

Grandiose name aside, what is a mega backdoor Roth IRA, and what is it to you?

Are you a high-income earner, highly interested in stockpiling significant savings for your future retirement and/or legacy goals?

If so, you’ll want to know more about this high-flying retirement planning strategy. It can throw a powerful, tax-wise punch for savvy super-savers.

To understand how the strategy works, let’s unpack its parts.

Part One: Making Basic Contributions

Most employees with access to a 401(k) or similar company retirement plan know they can defer a portion of their paycheck to participate in that plan. They also know they are limited to a federally mandated maximum contribution. In 2020, that maximum is $19,500, plus an additional $6,500 “catch-up contribution” for those 50 or older.

Contribution limits apply across pre-tax and Roth plan contributions, as well as across multiple 401(k) plans. For example, if you have two jobs, with access to two retirement plans, the sum of your contributions across both plans’ pre-tax and Roth accounts cannot exceed $19,500 (plus any applicable catch-up contribution).

Employer contributions do not count toward this limit, although you and your employers’ combined contribution cannot currently exceed $57,000 (or $63,500 for those 50 and older).

For most people, setting aside $19,500 annually for their retirement is more than enough. But what if you’re a high-income earner, and/or a supersaver as touched on above? You may want to save more, preferably in a tax-friendly manner. To make their retirement plans more attractive, a growing number of companies now allow employees to make additional contributions to their 401(k) plan in the form of after-tax contributions.

Part Two: Adding After-Tax Contributions

After-tax contributions allow employees to contribute beyond the $19,500 limit, up to $57,000 including employer contributions. For example, in 2020, if your employer contributes $5,000 to your 401(k) account and you max out your $19,500 pre-tax contribution, you can add up to $32,500 more as an after-tax contribution.

   19,500
+   5,000
+ 32,500
=$57,500

 

As the name suggests, after-tax contributions are made with after-tax money. In this way, they are like Roth contributions. However, the tax benefit of an after-tax contribution is not as great as a Roth contribution. While the your contribution is not taxed again at distribution, the growth on your contributions is taxed as ordinary income at the time of distribution.

 
Traditional/Pre-tax
Roth
After-tax

Tax benefit at the time of contribution

Yes

No

No

Growth taxed at distribution

Yes

No

Yes

Contribution taxed at distribution

Yes

No

No

 

Part Three: Doing the Two-Step Mega Backdoor Roth

Here’s where an additional step can take you far. To prevent the growth from being taxed again, employers typically allow employees to roll over after-tax contributions to a Roth account within the plan. This two-step process of (1) making an after-tax contribution, and (2) rolling over the contribution into a Roth account, is called a mega backdoor Roth contribution. Upon completion of your mega move, the assets enjoy the tax benefits of a Roth account. They grow tax-free with no tax on the distributions.

If you have access to after-tax contributions in your 401(k) plan, you can use the mega backdoor Roth to contribute up to $37,500 annually to your Roth account. If you were instead investing the same $37,500 in an ordinary taxable account, you’d end up paying annual taxes on any interest or dividend income, plus capital gains taxes whenever you sold any positions. Compared to a taxable account, the tax savings that accompany a mega backdoor Roth account could amount to tax savings as high as tens, or even hundreds of thousands of dollars over time.

Part Four: Incorporating IRAs

There’s one more part to ponder. Employers typically give you the option to roll over after-tax contributions to a company-sponsored Roth 401(k) account, or to your own Roth IRA account.

Rules for converting to a Roth 401(k) vary from company to company, but it is typically easier than converting to a Roth IRA. For example, a company can allow you to set up a daily, automatic sweep from your after-tax bucket into your Roth 401(k) … but not to a Roth IRA.

However, it can still be worthwhile to roll over the account to your Roth IRA where you’ll have more favorable withdrawal rules compared to a Roth 401(k). In particular, you can withdraw the amount you’ve contributed to a mega backdoor Roth IRA after 5 years without penalty. Thus, in an emergency, you retain penalty-free access to the contributions you’ve made to your mega backdoor Roth IRA. (This does not apply to the growth.)

The Sum of Your Retirement Planning Parts

If you are a high-income earner with extra cash flow to save toward retirement, a mega backdoor Roth contribution is worth exploring. That said, we don’t recommend planning for it in isolation.

If you have access to other tax-advantaged employer benefits, such as a non-deferred compensation plan, you will want to analyze the optimal amount to contribute to each. It’s also worth coordinating and developing a comprehensive financial plan and tax projections for all of your benefits, combined. Then meld this into the same for all your sources of retirement income, from Social Security and IRA accounts, to HSAs and taxable income.

With so many moving parts, it may sometimes feel as if planning for your ideal retirement is like a three-ring circus. So many acts to behold. So many balls in the air. Just take it one part at a time until it all comes together. And let us know if you could use some help with the juggling.

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Disclaimer: This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.

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Daniel joined Plancorp in 2019 after spending over a decade with a local Bay Area firm. He leads our Silicon Valley office and specializes in helping busy professionals optimize complex retirement and equity compensation plans. Daniel also researches socially and environmentally responsible investing for the firm. Daniel earned a BS in Economics and Biopsychology from the University of Michigan and completed the UC Berkeley Extension Personal Financial Planning program. More »