The Mega Backdoor Roth
Traditional retirement savings largely takes place within company-sponsored retirement plans, such as a 401(k) plan. The premise is simple: put money away directly from your paycheck and save money on taxes. However, for those with unique tax circumstances, Roth 401(k) plans are also available. The idea is the same as with a traditional 401(k), except that you don’t get a tax deduction when you make the contribution, and the money grows tax free thereafter and may be withdrawn tax free during retirement.
There are of course restrictions and nuances to how these accounts work, but generally you may contribute up to $19,500 (or $26,000 if you are over 50) to your 401(k) plan. This can be done in a traditional 401(k) or a Roth 401(k). However, there is a lesser-known retirement strategy that may allow you to save an extra $38,500 in a Roth IRA or Roth 401(k). It is called the “mega backdoor Roth”. Though, we have often been found calling it the “mega, ultra, colossal, ginormous backdoor Roth,” or any such combination of superlatives.
The reason this strategy is lesser known is that there are a lot of nuances and restriction as to who can participate. Here’s what you’ll need in order to take advantage of the mega backdoor Roth:
- A 401(k) plan that allows you to contribute after-tax dollars beyond the pre-tax limits. If your company’s plan does not allow after-tax contributions or the ability to contribute larger amounts, start lobbying your HR department now. This feature is separate from your pre-tax traditional 401(k) contributions or Roth 401(k) contributions.
- A 401(k) plan that allows for in-service distributions to a Roth IRA or lets you move after-tax contributions into the Roth 401(k) part of the plan.
- Maxed out traditional 401(k) and Roth IRA contributions. Most people considering this strategy have already outgrown a traditional Roth IRA account.
- Additional savings you would like to stash away in a qualified account.
Note that the normal rules around Roth accounts still apply. You must be over 59½ and wait five years after depositing to avoid a 10% early withdrawal penalty. If you are under 59½, your earnings may be subject to taxes and penalties on withdrawal.
While traditional 401(k) contributions are capped at $19,500, you and your employer combined can contribute up to $58,000. If you are over 50, that number increases to $64,500 due to allowances for catch-up contributions. If your employer does not have a match, or does not make profit-sharing contributions, you can add up to $38,500 of after-tax dollars into the plan. If your company does have a match and/or a profit-sharing contribution, you will have to subtract those contributions from the $58,000 total. Estimating your match should be straightforward, though profit-sharing contributions can change from year to year.
After you have already maxed out your usual 401(k) savings for the year, these are the steps to take for the mega backdoor Roth:
- Make your calculated after-tax contribution to your 401(k) plan, which will be up to $38,500
- If your plan allows in-service distributions, rollover the after-tax contributions to a Roth IRA. This needs to be done immediately to prevent any earnings on those funds, which would be subject to tax.
- If your plan has a Roth 401(k) provision, you may rollover the after-tax contribution in-plan to the Roth 401(k).
Unfortunately, the ability to do a mega backdoor Roth on most plans is limited because of Actual Contribution Percentage (ACP) testing. ACP testing is used to determine if matching contributions are discriminatory in favor of Highly Compensated Employees (HCEs). To pass the ACP test, there would have to be non-HCEs making after-tax contributions to their plans. However, if the plan only has HCEs, then a mega backdoor Roth is still possible.
This is a complicated and tricky process that will require the cooperation of your employer and likely the third-party administrator (TPA) on your retirement plan. Feel free to call us if you have questions or would like guidance on this topic.
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