For years, the Mega Backdoor Roth IRA was a rarely used tool applicable only to a select number of people and truly understood by even fewer people. With the rise of the gig economy and more and more people have second and third income streams, the Mega Backdoor Roth IRA is more relevant than ever. While a bit more complex than something like a standard 401(k), putting the time into understanding this tool can be quite lucrative. Depending on your situation, the Mega Backdoor Roth IRA can help you contribute tens of thousands of dollars into a Roth IRA account on an annual basis on top of typical retirement account contributions. This guide to the Mega Backdoor Roth IRA will aim to fully explain how the Mega Backdoor Roth IRA works, how to execute this tool and which types of individuals it applies to.
How does the Mega Backdoor Roth IRA work?
At a high level, this process allows individuals to contribute money above the maximum contribution to a 401(k) as after-tax contributions, then convert these funds into a Roth IRA. What this means is that now an individual can max out a 401(k) with $19,000 as of 2019 in pre-tax contributions, max out $6,000 in IRA contributions, then contribute an additional chunk of money (up to $37,000 in 2019) into the Roth IRA via the 401(k) as after-tax money.
Note the key maximum contribution levels as of 2019:
- Annual IRA contribution: $6,000 ($7,000 if 50 or older)
- Annual salary-deferral limit to 401(k): $19,000 ($25,000 if 50 or older)
- Annual total contribution to 401(k): $56,000 ($62,000 if 50 or older)
Why is salary-deferral limit different from total contribution with respect to the 401(k)? The reason for this is that there are two types of contributions for a 401(k): contributions made by the employee or individual and contributions made by the employer. The money that the employee contributes himself or herself is called salary-deferral contributions. This money is taken out of salary before you pay taxes on it and put into the 401(k) plan. The maximum amount you can do in this bucket as of 2019 is $19,000. Additionally, employers can contribute to an individual’s 401(k) plan via matching or profit sharing. The key here is that combined the total maxes out at $56,000 in 2019 (or $62,000 if you are 50 years old or older).
Now the key to the Mega Backdoor Roth IRA is when an individual maxes out his or her own contributions up to the $19,000 level, but is not maxing out the other component of 401(k) contributions which are a bit more out of their control. For an individual contributing $19,000 in salary-deferral contributions but getting no contributions from an employer, there is essentially $37,000 worth of contributions not being utilized. The Mega Backdoor Roth IRA not only gives an individual the opportunity to use that $37,000 worth of contributions, but it allows the individual the opportunity to put that money into a Roth IRA which is even more attractive for many individuals than a 401(k).
Once the $19,000 is maxed, if your 401(k) plan allows it (more on this later), you can begin contributing additional money after-tax (this is different from the salary-deferral contributions which are pre-tax) into the 401(k). When those contributions are made, the money can be immediately converted into a Roth IRA.
If an individual maxes out his or her 401(k), his typical IRA contribution and fully takes advantage of the Mega Backdoor Roth IRA, he or she could essentially contribute $19,000 into a 401(k) and $43,000 into a Roth IRA in 2019. That’s incredible!
An extension on the standard backdoor Roth IRA conversion
You may have heard of the backdoor Roth IRA conversion, but not the Mega Backdoor Roth IRA. Let’s explain how these are similar and how they differ.
The Roth IRA has limits based around how much money an individual earns. If an individual earns more than $122,000 in 2019 (or $193,000 as a married filing jointly scenario), the amount you can contribute to a Roth IRA begins to phase out. If you earn $137,000 individually or $203,000 jointly, you can’t contribute to a Roth IRA at all. Kind of…
Fortunately, for high income earners, there’s a commonly used way of getting around this income limit threshold. Essentially, you can still contribute to a non-deductible traditional IRA. This means that you can put money into an IRA, but you won’t get a tax benefit because you make too much. But, then you can then just convert that traditional IRA into a Roth IRA. By doing so, you just contributed money into a Roth IRA despite earning more than the IRS says you can in order to contribute to an IRA.
Then, you just repeat this process every year. Every year where you make too much to contribute directly into a Roth IRA, you simply contribute the money into a traditional IRA (and do not take a deduction), then convert the funds into the Roth IRA.
Now in order to do this every year, you can’t have a pre-tax IRA account sitting around. When you convert a traditional IRA to a Roth IRA, it converts all the assets into the Roth IRA. As such, some investors may have to convert a larger chunk (and pay taxes on it) of assets in a traditional IRA on the first round of conversion to the Roth IRA. Then, in the subsequent years since there’s no money sitting in a traditional IRA, you can simply convert the contributions you just made into the Roth IRA.
Thankfully, most online brokerages actually make this process pretty easy. I set this up myself not long ago at Charles Schwab. I already had a Roth IRA and a Rollover IRA account with a small amount of money that I rolled over from a 401(k) I had briefly with a previous employer. I set up a new traditional IRA, contributed the max for the year into the traditional IRA, then I converted both the Rollover IRA and the newly created traditional IRA into the Roth IRA. It’s worth noting that after you do the conversion, the other accounts still exist. For practical purposes, you’re just converting the funds (cash + assets) from one account to another. Again, online brokerage interfaces make this relatively simple, and if you still have questions, you can always just call customer support.
The Mega Backdoor Roth IRA move takes the idea behind the standard Roth IRA conversion and expands upon it enabling individuals to push much more money into a Roth IRA each year. Instead of converting assets from a traditional IRA, however, it is converting some of the assets from a 401(k) account into a Roth IRA account. Within your 401(k) account, pre-tax contributions and after-tax contributions will be segmented from one another. Only the after-tax contributions will be eligible to move into the Roth IRA via the Mega Backdoor Roth IRA method.
401(k) criteria needed for the Mega Backdoor Roth IRA
Not every 401(k) account is eligible to be used for this process. There are two main elements that must be a part of your 401(k) plan for this to work. First, after-tax contributions must be allowed. This will be the contributions that you make above and beyond the $19,000 in pre-tax contributions. Only the after-tax contributions can be used in the Mega Backdoor Roth IRA conversion.
Secondly, in-service withdrawals must be enabled. In-service withdrawals essentially enable 401(k) account holders to withdrawal the after-tax money (and push it into the Roth IRA).
Depending on your 401(k) plan, you may or may not have these two key elements a part of the plan. These elements are often not advertised as they are lesser known features, so if you work for a large company, you may need to contact Human Resources or individuals who can speak to the particulars of the 401(k) plan in effect.
For those of us who use Individual 401(k) plans, setting up the 401(k) plan in order to enable the Mega Backdoor Roth IRA is very doable since essentially you can setup the plan however you want. Now, most people who setup Individual 401(k) plans through online brokerages such as Charles Schwab, Vanguard, etc. These online brokerages make it super simple to setup individual 401(k) plans. They essentially create a standard plan document for you which activates the plan. In order to enable the two key elements of after-tax contributions and in-service withdrawals, however, you may need to go through some extra steps utilizing some third parties.
A third party can create a modified 401(k) plan document that outlines the plan in a way to make the after-tax contributions and in-service withdrawals compliant. You can then keep the plan document in your records and if you ever run into questions with the IRS, the plan document can be cited if your Mega Backdoor Roth IRA approach is questioned. To sum up, if you have an Individual 401(k), executing the Mega Backdoor Roth IRA is very doable. It just takes a little more work. But as we’ve shown here, we think the extra work is worth it as this process can be quite lucrative for your retirement savings.
Step by Step Process for Executing the Mega Backdoor Roth IRA Conversion
Step 1 – Maximize your pre-tax contributions to the 401(k)
First, you want to push the maximum amount of pre-tax contributions into the 401(k) plan. In 2019, this is $19,000. If you are eligible for catch-up contributions, this amount is $25,000.
Step 2 – Maximize your after-tax contributions to the 401(k)
Next, you need to determine how much to contribute to the maximize your after-tax 401(k) contributions. The logistics of this might be tricky as often times, individuals are setup to contribute money as a percentage of your paycheck. If you have to talk to the plan administrator in order to facilitate this, go ahead and do so.
Make sure that these contributions are designated as after-tax contributions. There is sometimes confusion between after-tax 401(k) contributions and Roth 401(k) contributions. Ensure that these are designated as after-tax 401(k) contributions.
Step 3 – Withdraw the after-tax portion of the 401(k) balance to your Roth IRA
Once you’ve made the appropriate amount of after-tax contributions for the year, you can go ahead and withdraw these monies as an in-service (non-hardship) withdrawal. Note that if you have any earnings on this portion, the amount of the earnings will be taxable at the time of the transfer. You can attempt to minimize this by doing withdrawals on a regular basis immediately after any after-tax contributions are made to the 401(k).
Why utilize a Roth IRA?
A Roth IRA means that you’re building retirement income that will not be taxed at a later date. As opposed to a 401(k) or traditional IRA that utilizes pre-tax contributions, a Roth IRA utilizes after-tax contributions. But the money in the Roth IRA grows tax free then is withdrawn tax free. This is incredibly powerful.
Additionally, by utilizing both a 401(k) and a Roth IRA, you’re diversifying your tax risk a bit. As your 401(k) builds up, you’re building up a chunk of wealth that you will be able to use in retirement, but you will be taxed on this money as taxable income when you withdraw the money. Then, you’ll be able to use the Roth IRA money as income that is not taxed. The combination of the two can be a very nice scenario during your retirement. Even more, depending on other events during a given year, having the flexibility to use taxable income some years and non-taxed income other years can be quite beneficial. Simply put, a Roth IRA is a great tool, especially if you’re already contribution to a 401(k) with pre-tax dollars.
Lastly, Roth IRAs are some of the most flexible retirement accounts. Roth IRAs let you withdraw contributions early without penalty if you need the money. Lastly, there are additional flexible benefits such as the provision that allows you to pull up to $10,000 of earnings out of a Roth IRA to pay for a first home (if the Roth IRA has been contributed to for at least five years). Interestingly, Roth IRAs are even awesome accounts to setup for your kids!
The Mega Backdoor Roth IRA is one of the more lesser known strategies and tools that savvy investors and savers can utilize in order to make some very significant long-term moves. Imagine executing this process year-after-year for a decade or more. The amount of money being built up in both your 401(k) and Roth IRA would get very substantial over time.
Yes, the process is slightly more complicated than most simple retirement account funding processes and it does require a little bit more work, but we strongly believe that the benefits make up for the additional effort.
If you embark upon this process, it’s important to keep really accurate records. Staying organized and logging all contributions (both pre-tax and after-tax) to your 401(k) plus all conversions will be huge for you down the road. Having a well organized and accurate system that you can reference at any time down the road is really important if you utilize the Mega Backdoor Roth IRA method. Put the time in to thoughtfully consider this method, to setup the process correctly and to keep detailed records of all transactions and conversions. If you do so, you’ll find yourself with quite a bit of wealth in your retirement years. Good luck!