Yes, your employer is hiding a Ginormous Mega Backdoor Roth 401k. What now?
You qualify for a Mega Backdoor Roth 401(K) if you have
- Maxed out 401(k) contributions
- An employer-sponsored 401(k) with voluntary after-tax contributions
- An employer-sponsored 401(k) with the ability to perform in plan conversions
- Or the ability to withdrawal after-tax contributions
This (somewhat complex) tax strategy can allow you to contribute up to $37,500 into a Roth IRA or to a Roth 401(k), where it can grow tax-free. How does that work?
A Quick Retirement Account Primer
If you’re familiar with different types of retirement accounts, skip this section.
| IRA | ROTH IRA | 401 (k) | Roth 401(K) | |
|---|---|---|---|---|
| Taxation | Pre-Tax, Taxed on Withdrawal | Post-Tax | Pre-Tax, Taxed on Withdrawal | Pre-Tax |
| Contribution limits | $6,000 ($7,000 for 50+) (Modified rate for Singles earning $125,000+, Joint Filing at $140,000+) | $6,000 ($7,000 for 50+) (Modified rate for Singles earning $125,000+, Joint Filing at $140,000+) | $19,500 ($26,000 for 50+) | $19,500 ($26,000 for 50+) |
| Max Income | $140,000 (Single) $198,000 (Joint File) |
$140,000 (Single) $198,000 (Joint File) |
none | none |
In 2021, the IRS limits the total employer and employee contributions to ALL retirement plans to $58,000, or to $64,500 including the $6,500 catchup for 50+.
How Does the Mega Backdoor Roth 401(K) Work?
A Mega Backdoor Roth 401(K) contribution essentially takes advantage of massive after-tax contribution buckets allowed by most employers. Not everyone allows these. Additionally, you’ll have to follow up by converting after-tax contributions in plan to Roth 401k or rolling over from the 401(K) to a Roth IRA. This step can be taken all at once, but you’ll have to be careful to prevent tax complications. Also, you will need to be mindful of the Pro-Rata rules that apply in regards to existing traditional IRA balances.
After-Tax Contribution Buckets – The IRS limits personal 401(K) contributions to $19,500 in 2021. Employers can contribute, up to a total of $58,000 ($63,500 for 50+). With an optional after-tax contribution through the employer, you could then make up the additional employer’s contribution as an “after tax contribution bucket”. You could then do an in-plan conversion into the Roth 401(K) or rollover to a Roth IRA if allowed.
So, in a normal scenario:
George earns $154,000 with Company A. He contributes $19,500 to his 401(k). His employer matches $0.50 to the dollar, up to 3% of total income. So, the employer contributes an additional $4,620. George’s total contribution that year is $24,120. Because his kids have recently graduated college and he has extra cashflow, George can easily redirect funds from that expense to his 401(k). His employer will allow him to contribute up to $33,880 from his post-tax income to his 401(k). Because his employer also doesn’t impose penalties for withdrawing money from the employer account, George performs an in plan conversion of the money into a Roth 401(K). Alternatively, he could roll the money over into a Roth IRA with similar benefits.
No-Hardship Clause? – If your employer doesn’t allow you to withdraw 401(K) funds while working with them, it may be worthwhile to use the optional post-tax contributions anyway. However, this depends on your total income taxation at the time of quitting the company. For this reason, you should always get advice from a trusted advisor or tax professional.
Why You Might Want a Mega Backdoor Roth 401(K)
If you have extra cash-flow and want to increase your total savings, a Mega Backdoor Roth 401(K) offers a lot of advantages. These primarily offer advantages to individuals who:
- Are meeting the $19,500 maximum 401(k) contribution
- Are either maxing out the $6,000 IRA contribution or earn to much to do so
- Have access to an employer-sponsored 401(k) account with optional after-tax contributions
- Preferably a no hardship withdrawal clause, allowing you to withdraw money from an employee-sponsored 401(K) while working with the company.
If your employer does not offer a 401(k) with optional after-tax contributions, you cannot use the Mega Backdoor Roth 401(k). That’s unfortunate. On the other hand, if you qualify for normal IRA/Roth IRA contributions, make those first.
What to Watch out For?
A Mega Backdoor Roth 401(K) means moving post-income tax income into a 401(K) account and converting in plan to the Roth 401(K) or rolling over to a Roth IRA. This can result in tax complications. It’s crucial that you talk to a tax professional before doing so. In addition, if you have more than one IRA account, your taxes might become more complicated. It’s often a good idea to consider consolidating accounts such as Simple IRAs into a single 401(K) or Roth 401(K) before proceeding.
It’s also crucial to calculate potential taxes at the time of rollover. If not handled properly, you could end up paying double tax on the additional contribution (income tax + at time of contribution to the Roth 401(K). Depending on your situation, it might also be better to use a Roth IRA or a Roth 401(K) – you should consult with a tax specialist for more information. Here, the largest factor is that if you contribute money to a 401(K), you’re contributing deductible and non-deductible funds. The non-deductible funds can be transferred to the Roth 401(K) tax free because you’ve already paid the income tax. The standard 401(K) contributions cannot. Therefore, you might have to pay tax on any amount you rollover from a 401(K) to a Roth 401(K) with the Mega Backdoor strategy, even if it’s just a percentage of what you rollover.
The Mega Backdoor Roth 401(K) is an important tax strategy for thousands of Americans who have either maxed out contributions or who earn too much for traditional IRA. It allows you to maximize total contributions for your retirement, while reducing tax and what you owe now. However, this is a complicated tax move, and you should never attempt it without a consultation with a retirement planning and tax specialist.
If you’re curious, or ready to see if a mega backdoor Roth 401(K) is right for you, Tangent Retirement can help. Our tax agents specialize in retirement planning and we can help you navigate the complex tax decisions to ensure your planning and retirement savings are managed to your best advantage.
This information is for reference only and should be reviewed with a qualified professional as you situation may vary from others. Nothing mentioned above is a guarantee nor should this be considered advice.
Golden State does not and cannot deliver tax advice and the material herein is for information only. Please consult a qualified tax professional for opinions related to your particular situation.
Investment advisory services are offered through Golden State Equity Partners, LLC, an investment adviser registered with the U.S. Securities and Exchange Commission. Tangent Retirement is a DBA of Golden State Equity Partners, LLC.
