Mega Backdoor Roth
The Mega Backdoor Roth contribution proves to be one of the most powerful wealth building activities available. This article and video continues with our tax-free growth theme and picks up where we left off from the backdoor Roth IRA contribution video and article.
Requirements for the Mega Backdoor Roth
Before we dive into the logistics, it is important to know that you need to have a few items in place for this strategy to be viable.
1) The first requirement is access.
Unfortunately, not everyone can utilize the Mega Backdoor Roth contribution. In order to take advantage of the strategy, the first step is to have access to a 401(k) plan. If you have access to a 401(k), you then need to check if your plan provides the required features. You are going to ask your HR department if the plan allows for what is called an in-service conversion or an in-service rollover (I’ll explain these later in the article). Whether the plan allows this or not will be more or less a flip of a coin. If it offers either option, you’re in luck, keep reading.
2) The second requirement is excess cash flow.
This strategy only works for those of you that are on that “next level” of excess cash flow. This excess could come from a high income, or for those of you with tight control over your savings. To give you an idea of what the amount looks like, if you are already maxing out your 401(k) plan and have tens of thousands in excess cash flow leftover, this strategy could be a life changer.
When most people think of contributing to their 401(k), they think of the Roth or Traditional contribution methods. What few people are aware of, is the existence of a third contribution method called the “after-tax contribution”. The Mega Backdoor Roth utilizes this after-tax contribution method.
How does the strategy work?
First, Notes on the 401(k)
Remember that you are limited in the amount you can contribute to a 401(k) plan. This limit comes in two forms.
1) The first limit comes in the amount that can be deferred out of your paycheck and into the plan. If you are under the age of 50, the 2020 limitation is $19,500. If you are over 50, the IRS allows a catch up contribution for a total deferral limit of $26,000.
2) The second limitation is in the total amount of money that can go into a 401(k) plan. The IRS puts the total limit to $57,000 for those of us under 50. Participants over 50 see their catch up limit increase the amount to $63,500.
Well, if you are only allowed to defer $19,500, but the plan can hold $57,000 – where does that excess $37,500 come from?
For you fortunate employees, some or all of this amount may be filled by your employer. This could come from profit sharing, or the employer providing a match to your contributions.
But in many cases even a generous employee match won’t fully fill the difference. For example, a well compensated employee with a salary of $250,000 maxing out their 401(k) deferral and receiving a match of 3% would only see $7,500 of their $37,500 used ($250,000 * .03). So again, how does that remaining gap get filled?
That gap is filled by after-tax contributions.
Back to our example of someone making $250,000 a year with their employer matching them dollar for dollar 3%.
Recall that they’ve maxed out there $19,500 deferral and the employer contributed $7,500. Now if they have the cash flow to support it, they can make $30,000 in after-tax contributions into their account to hit the $57,000 total threshold.
It is important to recognize that the $30,000 after tax contributions go into a separate 401(k) bucket that is different from the Traditional and Roth contributions. The mechanics of after-tax contributions work similar to that of non-deductible IRA contributions, which I explained in that previous backdoor Roth IRA video if you need a refresher.
However, since we’d prefer the tax-free growth of the Roth over the tax-deferred growth of after-tax contributions, we want to transition those contributions to Roth as quickly as possible.
Enter the Mega Backdoor Roth
There are two essential processes that can be used to convert the after-tax money to Roth:
1) Conversion within the account itself
In this scenario you are never leaving the 401(k). You are simply converting the money from the after-tax portion of y0ur plan into the Roth bucket of your 401(k) plan. This only works if your plan allows for the in-service transition and the process operates very similar to the back door Roth.
In the event that your plan doesn’t allow internal conversions, you will use the Rollover strategy. This rollover action requires your plan to allow in-service distributions. “In-service” means you are able to process the rollover even while you’re still working at the company.
Some plans will only allow you to rollover money from a 401(k) once you’ve left the company, so this is an important distinction.
If allowed, you will use the in-service distribution to rollover only the after-tax portion of your contributions directly into a Roth IRA.
Theoretically in our example, this employee either could have converted their $30,000 directly from after-tax to Roth within the plan, or rolled that $30,000 of after-tax money out of the 401(k) and into a Roth IRA – whichever option the plan allows for.
Benefits of the Mega Backdoor Roth
Let’s review just how much more growth this strategy presents.
Regular Roth IRA
Take a 40 year-old individual, who will retire at 65 years old. That would be 25 years worth of retirement fund growth. Now as an example, let’s say they have an IRA and contribute the full $6,000 a year to hit the annual limit. Using a reasonable 8% yearly rate of return, that would equal almost a half a million dollars of completely tax-free money. Not too shabby. But now, let’s see what adding the Mega Backdoor Roth does.
Using the Mega Backdoor Roth
In this example, let’s just focus on the tax-free components. You’ll recall employer contributions are always made pre-tax (traditional) and not added to your Roth bucket. Let’s again then assume an 8% return in 25 years. In this case, we did our full $19,500 towards the Roth 401(k) bucket. Followed by $6,000 in a back door Roth contribution, and $30,000 in after-tax contributions then converted to Roth.
That total would be $55,500 per year in Roth contributions. This is clearly going to be extremely powerful.
How much exactly? $55,000 per year at 8% interest over that same 25 year stretch leads to over $4 million in tax-free money.
Why use this strategy?
Again, unfortunately not everyone has access to this strategy even if they have the cash flow to support it, but if you do, you can see why it proves so powerful.
If you’re someone who’s generating sizable excess cash flow each year and don’t have a strategy for it, you are likely leaving enormous opportunity on the table. If this is a scenario you weren’t aware of, this is just one of the handful of these types of strategies we work on with clients. We’d love to help you too. You can get in touch by scheduling a time to talk here.