April 8, 2021

Is The Mega Backdoor Roth Too Good To Be True?

READ TIME: 8 MIN.

A mega backdoor Roth is a special type of 401(k) rollover strategy used by people with high incomes to deposit funds in a Roth individual retirement account (IRA). This little-known strategy only works under very particular circumstances for people with plenty of extra money they would like to stash in a Roth IRA. If that's you, here's what you need to know.

Roth Account Basics

Before outlining the mega backdoor Roth, you need to understand how Roth retirement accounts and backdoor Roth IRA conversions work in general.

Roth Contribution Basics

Roth retirement accounts, like the Roth 401(k) and the Roth IRA, let you contribute money you've already paid income taxes on. In exchange for these post-tax contributions, you don't pay a dime in income tax on qualified withdrawals in the future.

Nothing beats tax-free income, right? If your employer offers a Roth 401(k) option, anyone can contribute, regardless of their annual income. But not everyone is eligible to contribute to a Roth IRA

For tax year 2021, investors filing income taxes as single must have a modified adjusted gross income (MAGI) of $140,000 or less per year to be eligible to contribute to a Roth IRA. Those filing taxes as married must have a household MAGI of $208,000 or less per year. If you meet these qualifications, you can contribute up to $6,000 ($7,000 if 50 or over) per year as of 2021.

Backdoor Roth IRA Basics

If your income is above the thresholds above, you cannot directly contribute to a Roth IRA. However, a backdoor Roth IRA conversion lets high-earners roll funds from a traditional 401(k) or traditional IRA into a Roth IRA.

To simplify a somewhat detailed process, you'll first want to get your money into a traditional IRA. If you aren't doing that through a direct deposit, you'll need to roll money from a traditional 401(k) account into a traditional IRA. Then you convert the traditional IRA to a Roth IRA. This almost always involves paying income taxes on any funds being rolled into the Roth account that have not previously been taxed, which is why you'll want to do this as soon as you can after you deposit funds into a traditional account to minimize potential gains.

There are no income restrictions on who can do a Roth IRA conversion. Contributions made to the traditional IRA must abide by the IRS annual contribution limits during the year you make them. You can get around these constraints, however, by rolling funds from your workplace retirement plans, which have much higher contribution limits.

How Does a Mega Backdoor Roth Work?

A mega backdoor Roth lets you roll over up to $45,000 from a traditional 401(k) to a Roth IRA, all without paying any taxes you'd normally owe with such a conversion.

Note that pursuing this strategy only makes sense if you've already maxed out your annual 401(k) and IRA contributions and you still have a relatively large chunk of cash that you'd like to get into a Roth IRA.

In addition, you must be enrolled in an employer-sponsored traditional 401(k) plan that permits after-tax contributions and in-service withdrawals.

  • After-tax contributions. These contributions are generally made to a traditional 401(k) that you can only make once you've reached your personal contribution limit for the year. As the name suggests, they are made with money you've already paid taxes on. Roth contributions are treated this way, but unlike Roth dollars, earnings on after-tax contributions are taxable upon withdrawal. So why make after-tax contributions? They can still help you avoid capital gains taxes.
  • In-service withdrawals. Most but not all 401(k) plans let participants take withdrawals from their accounts while they're still employed. These in-service withdrawals are a necessary part of the mega backdoor Roth process because you don't want your money to generate too many returns before you move it into a Roth account. Any gains over your after-tax contribution amount will be taxed when you transition accounts. If your plan does not allow these, you can still do a mega backdoor Roth after you part ways with your employer, but keep in mind that you'll probably owe substantial taxes on earnings if you try to convert those as well.

    If you're self-employed and use a solo 401(k) plan, you may be ahead of the game. Not all major solo 401(k) providers allow for after-tax contributions and in-service withdrawals by default. But if yours doesn't, you may be able to customize your plan relatively easily and inexpensively to allow for these.

    401(k) Contribution Limits Are Key to the Mega Backdoor Roth

    Remember, you can't access the after-tax contributions required for a mega backdoor Roth until you've reached your 401(k) employee contribution limit. That's $19,500 in 2021, or $26,000 if you're 50 or older.

    This isn't the only 401(k) contribution limit that exists, though. Your employer also has one: It can contribute up to enough to bring your total contribution to $58,000, or $64,500 if you are 50 or older. If your company isn't maxing out its part of the deal, you may be able to make up the difference with your own after-tax contributions.

    Assuming no employer contributions, the maximum you can contribute this way is $39,500 (or $45,000 for people 50 or older) in 2021. But chances are your employer is contributing some amount to your future.

    Here's the mega backdoor Roth math could work: Take someone who's younger than 50 and has maxed out their annual traditional 401(k) contribution. This individual's employer offers a standard 6% matching contribution.

  • $19,500 individual contribution + $1,170 employer match = $20,670
  • $58,000 401(k) total limit – $20,670 in standard contributions = $37,330 available for after-tax contributions

    Once you have your after-tax contribution maximum, you'll want to contribute up to that amount to your traditional 401(k) and then roll that amount over into a Roth IRA at the brokerage of your choice. Any standard pre-tax contributions should remain in your 401(k) account, unless you want to pay taxes to convert them as well.

    Complete the Rollover Before Earnings Accrue

    You want to roll over your money as soon as possible because you want to minimize the likelihood your funds see any investment returns as these will be taxed in the conversion.

    If your after-tax contributions do end up generating investment growth, the IRS allows you to split up the funds, rolling the after-tax contributions into a Roth IRA and the investment earnings into a traditional IRA.

    Other Things to Keep in Mind

    401(k) withdrawals are generally subject to something known as the pro rata rule. What this boils down to is that you typically can't choose to exclusively withdraw pre- or post-tax contributions from your traditional 401(k). You must take out an amount equal to the ratio of your contribution sources.

    If you had a traditional 401(k) balance of $100,000, then, and $80,000 of it was from pre-tax contributions and $20,000 was from post-tax, each one of your withdrawals would take out $8 of pre-tax money for every $2 for post-tax money.

    That means you can't exclusively withdraw post-tax contributions if your traditional 401(k) has a mix of both pre- and post-tax contributions. If the latter is true, you'll have to empty your entire 401(k) balance to move all of your post-tax contributions in the mega backdoor Roth maneuver. This may not be a huge deal because you can easily move your pre-tax contributions to a traditional IRA, but it is something to keep in mind.

    If your employer tracks pre-tax and post-tax contribution amounts – as well as their growth – you might be able to get around this and simply withdraw the entirety of your post-tax contributions outright.

    One more thing: Even if your traditional 401(k) balance is $0 at the beginning of the calendar year and you only contribute to a Roth 401(k) before you reach your post-tax contribution threshold, you may still have pre-tax contributions in your traditional 401(k). That's because any employer contributions must be placed in pre-tax, non-Roth accounts. This means you may owe taxes on that money if you try to convert the entirety of your balance; or you can simply move your employer contributions to a traditional IRA.

    Who Should Consider a Mega Backdoor Roth?

    Before you get too excited about the ability to go above and beyond the typical $6,000-$7,000 per year Roth IRA contribution limits, it's important to understand that a mega backdoor Roth strategy is only suited to certain investors.

    Brent Weiss, CFP, co-founder of Facet Wealth, outlines the following scenarios when a mega backdoor Roth might make sense for you:

  • You have already maxed out your traditional 401(k) contributions.
  • You are ineligible for direct Roth IRA contributions because your income is too high.
  • You would like to contribute more money than the annual IRA limits.
  • You've already taken care of other key financial goals, like paying down debt, saving for college or saving for shorter-term objectives.
  • You have sufficient extra income or money to contribute on an after-tax basis.
  • Your company's 401(k) plan allows for both after-tax contributions and in-service withdrawals to a Roth IRA or transfers to the Roth 401(k) portion of the plan.

    "It's important to not adversely affect other areas of your financial life when deciding to contribute after-tax dollars," says Weiss.

    Why Do Some Companies Not Allow the Mega Backdoor Roth?

    Even if you have the extra cash and a 401(k) plan with the necessary features that would allow you to complete the mega backdoor Roth rollover, Weiss is quick to point out why some companies don't allow after-tax 401(k) contributions.

    "In many 401(k) plans, after-tax contributions would prevent the plan from passing non-discrimination tests," he says.

    The IRS limits how much money highly compensated employees can contribute to certain retirement plans relative to the contributions made by other employees in the same plan who are not highly compensated.

    "Since non-highly compensated employees generally can't save more than the traditional 401(k) limits, most plans would not pass the non-discrimination tests if they allowed after-tax contributions," says Weiss.

    Alternatives to a Mega Backdoor Roth

    If you're determined to save extra money for retirement, there are a few options beyond a mega backdoor Roth IRA.

  • Invest in a taxable account. "Buying and holding common stocks that don't pay dividends can work well to accomplish the same result if the goal is to leave money to the next generation," says Paul Axberg, CPA, CFP and president of Axberg Wealth Management "This works because the stocks grow tax-deferred, and at death, the heirs get a stepped-up basis to the value at the date of death. This makes all the capital gains become not taxable." If your stocks do pay dividends, you'll owe income taxes on those payments annually, though it may be at a lower rate than your other income.
  • Make a regular backdoor Roth IRA conversion. If your retirement plan lacks the elements necessary for a mega backdoor Roth, just stick with a regular backdoor Roth IRA conversion. Even if you make too much for a Roth IRA, you can make similar non-deductible contributions to a traditional IRA that you then convert to a Roth. But "make sure you do not have other pre-tax dollars in any kind of IRA, like SEP IRAs or SIMPLES IRAs, or you will create a taxable event," notes Weiss.
  • Contribute to a Roth 401(k). While this option doesn't provide a way to make big, extra contributions, you can get the tax-free withdrawals you crave by maxing out your annual contributions to a Roth 401(k).

    The Last Word on the Mega Backdoor Roth

    If you've got the income and a 401(k) plan that makes a mega backdoor Roth viable, you're in an advantageous position to save a hefty sum for retirement and enjoy the tax-free benefits of the Roth IRA and freedom from required minimum distributions (RMDs). And if the mega backdoor Roth isn't a fit for your situation or income, no sweat, you have options.

    As with all complicated retirement strategies, the best course of action is to speak with a tax professional or a financial advisor before considering a mega backdoor Roth conversion. You don't want to end up with what Axberg refers to as a "mega front-door tax bill" if you opt for this strategy without understanding all the moving parts first.

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