Mega Backdoor Roth IRA – what is it?

Does your 401(k) offer an after-tax component?  If so, you might be eligible to take advantage of the “Mega Back Door Roth IRA strategy.” 

For many people, contributing to a Roth IRA is a great way to save for retirement because of it’s tax advantages.  So long as you are over the age of 59.5 and you have had the Roth IRA for at least 5 years, all of your distributions in retirement are tax free.  Many experts anticipate that tax rates will be going up in the near-term and even if nothing is done by the current regime in Washington, the Tax Cuts and Jobs Act will sunset after 2025 meaning tax rates are going up regardless.  Couple that with the fact that the Federal Government has spent a lot of money recently as a result of the pandemic and we have a recipe for what could be the perfect storm.  Needing to generate more revenue, it’s easy to conclude that taxes will be going higher in the future which makes a Roth IRA even more valuable.

The challenge for many high-income earners is they are not eligible to contribute directly to a Roth IRA because their income is too high.  For 2021, a married couple with a Modified Adjusted Gross Income above $208,000 is not eligible to contribute to a Roth IRA. Many 401(k) plans offer a Roth component to the plan.  However, for high income earners, their CPA’s often prefer them to make before tax contributions in order to reduce their tax liability.

We have written about the option of doing the Back Door Roth IRA which is a wonderful strategy worth looking into.  For some, there may be another option as well.  More frequently these days, we are seeing 401(k) plans offer their employees the option of doing an after tax contribution. Nearly half of all employer-sponsored retirement plans are offering after tax contributions these days.  Make sure to check with your benefits department to find out if you have this after-tax component available to you.

The increase in after tax 401k’s has led to the rise of a strategy we like to call “the Mega Back Door Roth IRA strategy”.  Here is how it works:

  1. Your 401(k) plan must offer an after-tax contribution option.  After tax contributions are a separate “bucket” of money from your Traditional and Roth 401(k) contributions. 
  2. You make a contribution into this after-tax component.  Keep in mind that you receive no tax benefit for making the contribution. 
  3. Many plans allow for immediate or “in-service” rollovers to your Roth IRA.  If your plan allows for “in-service rollovers” then take advantage of it and roll the after-tax contribution over right away.  This enables all of your growth in the Roth component to also be tax free.  If your plan does not allow for “in-service rollovers” the strategy still works but just a little differently.  You will invest the after-tax contribution in the same manner that you would your pre-tax or Roth 401(k) contribution.  When you change jobs or retire, you can roll the after-tax contribution into a Roth IRA and the growth on it to your Traditional IRA. In this way you will avoid paying taxes immediately on the growth and you will never have to pay taxes on the part that you contributed.

So how much can you contribute to your “Mega Back Door Roth IRA?”  The IRS allows a 401(k) plan participant to put in $19,500 if you are under the age of 50 and up to $26,000 for those age 50 and older.  The total amount that can go into a 401(k) each year is $58,000 (plus an additional $6,500 if you are over the age of 50). All contributions for a participant to a 401(k) (e.g., salary deferrals, profit sharing, matching, designated Roth and after-tax) are included in a participant’s annual additions. If a participant exceeds their annual additions limit, a typical corrective method is a refund of contributions. Make sure to consult with your tax professional or financial advisor to learn more about the contribution limits.

There are some potential landmines that exist with this strategy and we want to make you aware of a few. If you contribute to your after tax 401(k) but take a distribution from it before attaining the age of 59.5 there is a 10% penalty imposed.  Obviously, the solution is to roll the after-tax contribution to your Roth to avoid this.  Also, some plans only allow for “in-service rollovers” after you reach a certain age like 55 or 59.5.  Get familiar with your 401(k) rules to see what options are available to you.

All in all, the “Mega Back Door Roth IRA strategy” allows you to contribute a whole lot extra into your Roth IRA and is a wonderful strategy to utilize if it’s available to you. If you would like to learn more please feel free to contact our office.