Use a Mega Backdoor Roth to Maximize Your Retirement Savings

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By Clayton Boone, CFA, CFP® and Matt Mormino, CFP®

We’re all pretty familiar with standard annual contribution limits for retirement accounts. The 2021 caps are the same as last year: $6,000 for an IRA and $19,500 for a 401(k)—higher if you’re 50 and over. But some companies’ 401(k) plans are structured to allow for additional after-tax contributions, which can create a “mega backdoor” through which you can funnel up to an extra $38,500 into your Roth IRA or Roth 401(k).

No kidding. You get to pump up your retirement savings to $58,000 each year ($64,500 if you’re 50 and older) and pay fewer taxes on your investment earnings by saving them in a Roth-style account.

We’ll walk you through how it works and if it’s a good move for you, but know now that this is complicated, advanced financial planning with the potential for some unexpected tax bills—definitely work with an expert on this one.

Is a mega backdoor Roth even possible with your 401(k) plan?

For lots of us, this strategy isn’t available. There are two prereqs—if you’re unsure about either, double-check with HR or contact your plan administrator.

  1. Your 401(k) plan must allow for after-tax contributions. Not all 401(k) plans even let you make after-tax contributions. Quick vocab lesson: after-tax is an entirely different contribution category from pre-tax and post-tax. (We’ve mentioned before how after-tax and post-tax used to be conflated.)
  2. Your 401(k) plan must also allow for in-service withdrawals or in-plan Roth conversions. In-service withdrawals (also called in-service distributions) mean you can take money out of your 401(k) while you’re still employed with the company, and an option is to roll it into a Roth IRA. In-plan conversions let you move your after-tax contribution into Roth dollars within the 401(k).

If you’re a no on either of these, the mega backdoor Roth isn’t a good strategy for you. Let’s say you’re a “yes” on both.

How a mega backdoor Roth works

The “real” limit on a contribution plan like a 401(k) is actually pretty high: this year, it’s $58,000 (or $64,500 for folks 50 and over). That max amount includes the $19,500 (or $26,000) employee elective deferral amount we’re most familiar with, as well as any matching contributions from your employer, profit-sharing, and your after-tax contributions.

When you use the mega backdoor strategy, you take all the money from the after-tax contribution to your 401(k) and quickly transfer it into either a Roth IRA or to Roth dollars within your 401(k) before it can accrue investment earnings. Once it’s in a Roth-style account, the money will grow tax-free instead of tax-deferred, which means you won’t end up owing taxes on those earnings. Ever. And neither will your beneficiaries. Pretty nifty.

Speed is key, which is why in-service withdrawals or in-plan conversions is one of the prereqs—you don’t want to have to wait until you leave your employer to move that chunk of money. If you leave it as an after-tax contribution in your 401(k), it’s going to be accruing taxable earnings the whole time. Speed is also part of what makes this strategy complicated. Some plans allow for automated in-plan conversions, but not all. Doing the process manually is complicated, and a financial planner or tax professional will definitely come in handy.

[sidebar] “Oh no! My after-tax contributions accumulated gains.”

Say you miss an in-service withdrawal or in-plan conversion and you’ve accrued some earnings. Not the end of the world. The IRS confirms you can shift the contribution portion into a Roth IRA and the gains portion into a traditional IRA, which is kind of a hassle, but you’ll preserve your contribution’s beneficial tax status.

Calculate your after-tax contribution amount

You’ll notice that we keep saying “up to $38,500” in additional contributions—that’s because everyone’s after-tax amount could be different. If you’re trying to make up the difference between the $19,500/$26,000 standard employee contribution amount and the $58,000/$64,500 max limit, you have to account for any employer matching and profit-sharing along the way.

Let’s walk through a couple of simple scenarios.

Jenny, 42
Max limit, based on age: $58,000
Salary: $100,000
Employee matching: Up to 3 percent of salary

If Jenny maxes out the $19,500 employee contribution, and her company matches $3,000, that means Jenny has room for $35,500 in after-tax contributions.

$58,000 (max limit) – $19,500 (Jenny’s employee contribution) – $3,000 (employer match) = $35,500 (Jenny’s available after-tax contribution)

Anand, 55
Max limit, based on age: $64,500
Salary: $100,000
Profit-sharing: 25 percent of salary

At 55, Anand has higher limits. If he maxes out his $26,000 employee contribution and gets $25,000 from his employer, Anand has room for $13,500 in after-tax contributions.

$64,500 (max limit) – $26,000 (Anand’ employee contribution) – $25,000 (employer profit sharing) = $13,500 (Anand’ available after-tax contribution)

One caveat: Some 401(k) plans do cap the amount you can contribute after-tax, so even if you have “room” to contribute more, you might not be able to. There are also some instances where a company’s highest earners wouldn’t be able to max out their after-tax contributions due to IRS nondiscrimination tests, which are designed to ensure those earning the most aren’t also saving at a higher rate than everyone else at their organization.

And it bears repeating: after-tax contributions aren’t deductible, and if left in the 401(k) plan instead of being shifted into a Roth-style account, the earnings could be taxed when withdrawn.

When you should consider a mega backdoor Roth

Mega backdoor Roths are an interesting option for high-earners looking for additional ways to save for retirement. It’s worth exploring with your financial planner if:

  • You’ve maxed out your personal 401(k) contributions. That comes first. When you’ve done that and still have more to save, you can consider going for a mega backdoor strategy.
  • You have additional funds you want to save for retirement. Mega backdoor Roths are a great way to sock away cash every year. Still, there are many other financial strategies to consider, and things like time horizon and liquidity are important considerations.

Clayton Boone, CFA, CFP® and Matt Mormino, CFP® serve as advisors at Brighton Jones.

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