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Retirement

Mega Backdoor Roth: A Super Simple Explanation

Overview

  • What is the mega backdoor Roth? It’s a strategy for people with regular 401k plans that allows them to put more money into a Roth retirement account (like a Roth IRA or Roth 401k) than is typically allowed.
  • How much more? In 2022, the contribution limit for a Roth IRA is $6,000 ($7,000 if you’re over 50). The contribution limit for a 401k account is $20,500 ($27,000 if you’re over 50). With the mega backdoor Roth, you can contribute up to $40,500 more to either of these retirement accounts.
  • Who should do this? People with traditional 401k plans at their jobs should look into the mega backdoor Roth. But for you to be able to, your company 401k plan must allow after-tax contributions, and Roth conversions on those contributions. Not every company plan offers this.

Roth retirement accounts like a Roth IRA and Roth 401k are extremely tax-advantaged. You get tax-free compounding and you don't have to pay any taxes when you withdraw from your nest egg in retirement (no matter how crazy your gains). There are people who've turned a few thousand dollars into millions inside Roth accounts. And they didn't have to pay the IRS a dime of it.

Because it’s so tax-advantaged, the IRS doesn’t just let you put away an unlimited amount into a Roth retirement plan. They set strict contribution limits each year. 

Roth account contribution limits for 2022:

  • Roth IRA: $6,000 ($7,000 if you’re over 50).
  • Traditional 401k: $20,500 ($27,000 if you’re over 50).

Additionally, the Roth IRA also has an income restriction. If your income is over $144,000 for the year, you’re not allowed to contribute at all.

The mega backdoor Roth strategy is a way to get around those limits and restrictions.

Since the restrictions are placed around CONTRIBUTIONS, we can use a different way to put the money in: CONVERSIONS.

There are no income restrictions with conversions and no limit on how much you can convert into an account.

Basically, we're going to go find a retirement account that has no income restriction and has the highest possible contribution limit set by the IRS. We're going to maximize that account, and then we're going to immediately convert it into our Roth IRA or Roth 401k.

Tip: High income earners are not allowed to contribute to a Roth IRA, but it doesn't restrict them from rolling over funds into it from another retirement account. This makes the mega backdoor Roth IRA strategy a fantastic loophole for high income earners who still want the benefits and tax-advantages of a Roth IRA.

To do this, we’ll make use of a lesser known retirement account: The after-tax 401k account.

The after-tax 401k is the perfect vehicle for this. It's different from a traditional 401k or a Roth 401k, and it has a much higher contribution limit at $61,000 ($67,500 if you’re over 50).

Since we can’t CONTRIBUTE more than $6,000 into a Roth IRA or Roth 401k, we’ll contribute $61,000 into the after-tax account, and then CONVERT it all immediately into a Roth account.

The result?

Instead of putting away $6,000 into a Roth IRA, or $20,500 into a regular 401k, we can put up to $61,000 into either of those accounts using the mega backdoor Roth strategy.

That's over 10x the contribution limit of a Roth IRA and nearly 3x the limit of a regular 401k.

How it works

The concept of a mega backdoor Roth is complicating the first time around. But once you get an understanding of how it works, it's actually quite simple.

  1. Before you can make any contributions to your after-tax account, you need to contribute up to the maximum of your regular 401k at work.
  2. Then, you need to calculate your employer's contribution match. Usually, it's 6%.
  3. Next, take the contribution limit of the after-tax account, and minus your regular 401k contributions + your employer's matching contributions.
  4. The amount you have left is how much you can contribute to your after-tax account.
  5. Once you fund your after-tax account, immediately convert those funds into a Roth IRA or a Roth 401k.

Let's go through an example:

Let's say that you're under 50 years old. This year, to max out your 401k employee contributions, you'll need to put in $20,500.

Your employer's matching contribution is 6%.

$20,500 x 0.06 = $1,230.

The contribution limit of an after-tax account is $61,000 for 2022. Minus your employee 401k contributions and your employer match from this number.

$61,000 - [$20,500 employee contributions + $1,230 employer match] = $39,270.

That's $39,270 more that you could put into your after-tax account, which would then get immediately converted into your Roth IRA or Roth 401k account.

Not every company offers the mega backdoor Roth

The mega backdoor Roth strategy is useful for anyone with a regular 401k plan at their work. However, whether you're able to do this or not depends on if your company plan allows it. Not every company offers 401k plans that support the mega backdoor Roth strategy.

For the mega backdoor Roth to work, your company's 401k plan must offer two features:

  1. It must allow after-tax contributions.
  2. It must allow Roth conversions on after-tax contributions.

Some well-known companies that offer the mega backdoor Roth IRA are Google, Facebook, Amazon, Apple, Microsoft, LinkedIn, Uber, and Yahoo.

Roth conversion options

After you contribute to your after-tax account, the Roth conversions can be done in two ways:

  1. In-service distribution through a rollover into a Roth IRA
  2. In-plan conversion into a Roth 401k.

Some company plans only allow in-plan conversions into a Roth 401k, and some company plans only allow in-service distribution rollover into a Roth IRA. If they offer both options, it's up to you to decide which account you want to maximize.

While in-plan conversions into a Roth 401k are simpler to do, rolling the funds into a Roth IRA is the preferred choice.

  • A Roth IRA gives you more investment options while with a 401k, you're limited to whatever your company plan offers.
  • A Roth IRA lets you withdraw the funds from your account with no penalty while with a 401k, you'll be penalized with fees and taxes if you withdraw before the eligible withdrawal age of 59½.
  • A Roth IRA has no RMD and can keep compounding for your entire life while with a 401k, you'll be forced to start making required minimum distributions once you turn 72 years of age.
  • A Roth IRA can be passed down tax-free. Because there are no RMDs, and withdrawals on inherited Roth IRAs are also tax-free, a Roth IRA can be the perfect vehicle for passing money down to your heirs.

Note that both types of conversions are not taxable events since you already funded the account with after-tax income.

Alternative option

If your company plan isn't set up to offer the mega backdoor Roth, you still have another viable option: The backdoor Roth IRA.

With a Backdoor Roth IRA strategy, high income earners who originally were not eligible for a Roth IRA can contribute to a traditional IRA first, and then roll over the funds into a Roth IRA.

If you have a side business, you could also look into the mega backdoor Roth solo 401k, which mostly works the same but has the added benefits a solo 401k plan gives you.

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