Mega Backdoor Roth Strategy

Recently a client wanted to switch their 401(k) Plan Provider in order to take advantage of the Mega Backdoor Roth IRA. I’ve helped many clients take advantage of this tax strategy but I’ve never had a client want to move their 401k plan to a new provider for that reason.

Not familiar with the Mega Backdoor Roth IRA? No problem, I’ll walk you through it.

What is the Mega Backdoor Roth IRA?

Although it sounds like a B-level horror movie, it’s a really cool investment strategy that takes advantage of current tax law.

Why would you do a Mega Backdoor Roth IRA?

The Mega Backdoor Roth IRA allows you to contribute an additional $38,500 into your Roth IRA by leveraging the fact that some employer 401k plans allow after-tax contributions up to the current limit of $58,000.

You might be wondering how the Roth contribution limit in 2020 and 2021 is $6,000 (and $7,000 if you’re 50+). How can you contribute $38,500?

Not sure about why a Roth IRA vs. Traditional IRA? Read this post about Roth IRA and Traditional IRA before you go further

Get the basics first: A Regular Backdoor Roth IRA Conversion

The Backdoor Roth IRA Conversion is a strategy to contribute to a Roth IRA when you are not eligible to contribute directly due to high income.

Remember, to be able to fully contribute to a Roth IRA, you have to meet the following income limits:

Roth IRA Contribution Income Limits (2021)

Single Filers        Married Filing Jointly

Phase Out Starts               $125,000              $198,000

Ineligible                            $140,000              $208,000

Don’t worry, if you make over the limits, and have earned income, you can still contribute to a non-deductible traditional IRA. The Backdoor Roth IRA uses this tactic to then convert the non-deductible traditional IRA contribution into a Roth IRA.

3 steps to the Backdoor Roth IRA

Step 1 – Ensure You Don’t Have Any Other Pre-Tax IRA Accounts

It’s important to know that this is an “all or none” conversion. What that means is if you are converting one pretax IRA account, you have to convert them all. For those pre-tax accounts that you don’t want to convert (IRAs, SEP IRAs, or SIMPLE IRAs, etc) you can roll them to your employer 401k plan.

Note: You can only rollover pre-tax money, so any previous non-deductible contributions are not eligible to rollover.

Step 2 – Make A Non-Deductible IRA Contribution

Once you’ve eliminated all your traditional IRA accounts, open a Traditional IRA Account and a Roth IRA Account at the same firm (insert shameless plug – we can open your Traditional IRA and Roth IRA). Then, contribute $6,000 (the 2021 limit) as a non-deductible contribution to your Traditional IRA.

Step 3 – Convert Traditional IRA To The Roth IRA

I suggest waiting at least one day after the money clears the deposit into your Traditional IRA before converting it. The IRA has no guidelines on this, but it’s good to show a clear step-by-step process of how you converted.

Ask your advisor to transfer the balance from the Traditional IRA to the Roth IRA. You will not owe taxes on the amount transferred because the contribution was “after tax” and therefore you’ve paid taxes on it.

Note: This is not tax advice. We recommend you consult your tax person.

The MEGA Backdoor Roth IRA – How it Works

If you followed the Backdoor Roth IRA strategy then you’re ready for the Mega Backdoor Roth IRA. This strategy takes advantage of the fact that the after-tax contributions to a 401k plan are treated just like a non-deductible Traditional IRA in the above example of the Backdoor Roth.

Note: Your employer 401k must allow …. If they don’t, we can contact them and explain the strategy and how to make the Mega Backdoor Roth advantage available. Just let us know, we want to help.

Background on after-tax 401k contributions.

The IRS limits on total 401k contributions is $58,000 in 2021. That means that you can contribute $19,500 pre-tax, and your employer typically contributes something. Some 401k plans then allow employees to contribute the remaining amount in after-tax contributions.

For example, let’s say your employer matches you $6,000 into your 401k. You can contribute $19,500 pre-tax, your employer puts in $6,000, and that leaves you $32,500 that you can potentially contribute after-tax if your employer allows it.

Mega Backdoor Roth and the Solo 401k Plan

This works for the Solo K too! If you have a solo 401k, you can setup your plan to allow for this strategy. We recommend this for every Solo K we set up for a client. This is a big advantage for small business owners.

Your 401k Plan at work must allow:

• After-Tax Contributions Above and Beyond the $19,500 Pre-Tax Contribution Limits
• In Service Distributions or Non-Hardship Withdrawals

If both of them are offered, you can then max out your 401k with after-tax contributions up to the contribution limit each year. You can then withdraw that money into your Roth IRA (and do the same process as a Backdoor Roth IRA).

While company 401k plans allow both after-tax contributions and in-service distributions are rare, they are out there and keep in mind we can help your employer make the changes necessary to allow this. Talk with your benefits manager about talking to us.

Mega Backdoor Roth IRA Conversion: A Step By Step Process

1. Maximize Your After-Tax 401k Contributions

The first additional step for the Mega Backdoor Roth IRA is that you need to figure out how much to contribute to maximize your after-tax 401k contributions.

This means understanding your employer’s plan, and then making the additional contributions. This can be a challenge because many plans require you to specify a percentage of your paycheck, versus a set amount. You also want to make sure that these contributions are counted as after-tax and not Roth 401k contributions.

The formula: Maximum allowed – your employee contribution – employer contribution = maximum amount of after-tax contribution

2. Withdraw After-Tax Portion To A Roth IRA

Once you’ve maxed out your after-tax contribution, you can withdraw that portion to a Roth IRA (only if your employer allows in-service non-hardship withdrawals). If they don’t allow them in the plan document, you need to wait until you exit the company, and you can rollover the after-tax portion into a Roth IRA.

Note: If you have any earnings on the after-tax portion, leave that for when you roll out of the plan with the rest of your pre-tax money to a rollover traditional IRA.

In-Plan Roth Conversions

An “alternate” Mega step 2 would be if the 401k allowed In-Plan Roth Conversions (IRS calls it In-Plan Rollovers to Designated Roth Account). With this, you can simply click a button with your 401k provider and rollover the after-tax portion to the Roth Account.

Solopreneurs with a Solo 401k Plan.

This works great for Solo 401k Owners. How Solo 401k Plans work. For many business owners, they may not hit the limit of $58,000 (in 2021) because profits were not high enough. However, since you’re the keeper of your own plan, you can ensure that your plan allows after-tax contributions AND in-service withdrawals.

So, let’s say you can only contribute:

• $19,500 in elective contributions
• $20,500 in profit sharing contributions

That only adds up to $40,000 in contributions. You could theoretically contribute another $18,000 in after tax contributions to your solo 401k, which you could then roll over as a mega-backdoor Roth IRA. That’s huge!  You must establish a plan that allows this up front.

Let’s wrap it up.

Hopefully you see what we see… that the Mega Backdoor Roth IRA has the potential to maximize tax savings. I suggest you maximize your 401k, IRA, and HSAs first before you do this.

It also works really well for people who are looking to make early withdrawals from their IRA or 401k.

Although this is considered a more advanced strategy, hopefully you see it’s not that complicated.