A Step-by-Step Guide to the Mega Backdoor Roth
The Mega Backdoor Roth is a nice way for high income earners to tuck away a ton of Roth money for retirement.
There are a couple of things you need:
- High Income
- a 401k Plan that allows after-tax contributions
- AND, either in-plan Roth 401k Rollovers or in-service distributions
This is a Step-by-Step Guide to how to do the Mega Backdoor Roth using my Mega Backdoor Roth as an example! In addition, we will review pros and cons of the strategy and a few advanced concepts.
How I Did My Mega Backdoor Roth IRA
First off, I’m a physician. I have yet to meet a physician who has a 401k Plan that allows for the Mega Backdoor Roth (anyone??).
My wife, however, who is an executive and a consummate person, has a decent 401k at her employer. More and more companies are using 401k plans that allow for the Mega Backdoor Roth. The IRS allows 401k plans to have a ton of flexibility. If you can’t do a Mega Backdoor Roth in your 401k, it is not because of IRS limitations, it is because your 401k Plan does not allow it.
Note, I say that this is how “I” did “my” Mega Backdoor Roth even though it is my wife’s plan. Regardless, I should say “we” did “our” Mega Roth, but she really doesn’t care to think about financial stuff. She actually hates it, which is fine by me because I love waiting on hold for hours while representatives read the plan documents to make sure that I can do what I already know I can do… Anyway, I did the legwork on this Mega Roth, so I’m calling it mine! I do the financial stuff and she rides the horses…. That’s fair right?
Regardless, she contributed the maximum $19k pre-tax by mid-year. She has a true-up, so she gets the entire match despite “front-loading.” If that is unclear to you, read my Guide to the 401k. Instead of contributing to both the employee pre-tax and after-tax all year long, it turns out she has a 409a plan that continues to collect matching dollars after you max out the employee contribution. So it makes sense to aggressively fund the pre-tax, and then fund the after-tax later (all while leaving enough cash flow for horses).
By mid-year, she switched to after-tax contributions. The after-tax money grew in the 401k, but what next?
My Mega Backdoor Roth IRA Rollover—In-Service Distribution
Around mid-December, it was time to call her custodian and rollover the after-tax money into a Roth IRA. She had already set up a Roth IRA to receive the rollover. Since it was $50 a pop to make an in-service distribution, and a long wait on the phone, I only did one distribution this year.
The downside of a single distribution—the ordinary income taxable earnings on the contributions are also converted. But, I didn’t want to suffer the headache of calling the 401k provider every two weeks to ask them to do a rollover. Or waste $100 a month doing so.
And it was a headache! I spent 45 minutes on the phone and had to talk to 3 reps before they even understood what I was trying to do. The third rep understood what a Mega Backdoor Roth is, and after “reading the plan document” for 10 minutes, he processed the rollover without delay.
In effect, we were able to transfer $13K of after-tax contributions and $200 of growth (which will be fully taxable at our ordinary income tax rate), into a Roth IRA.
This is a magic of a Mega Backdoor Roth. My wife is able to convert more to a Roth IRA than both she and I could contribute to a backdoor Roth IRA a year right in her 401k. More Roth money that will now compound tax-deferred and pay out tax free!
That’s my Mega Backdoor Roth saga.
Let’s go back to some basics and then go through a step by step process of a Mega Backdoor Roth.
What is a Mega Backdoor Roth?
What is a Mega Backdoor Roth? It is also known as an After-Tax 401k (which isn’t a great name for it, since you need the Roth rollover piece as well for it to make sense) or a “Super Roth.”
It is NOT the “Rich Man’s Roth” which is a marketing pitch for a cash value life insurance products.
In many ways the Mega Backdoor Roth is a supersize version of the Backdoor Roth IRA, but done in a 401k. IRAs, however, have contribution limits which are small, whereas 401k plans have much larger contribution limits.
It probably should be called a “Mega Backdoor 401k to Roth IRA rollover.” But that’s too wordy. Let’s call it a Mega Backdoor Roth. Or Mega Roth.
The goal: take after-tax money from your salary (that you have already paid taxes on) and get it into a Roth IRA. It is important to get it into a Roth IRA, because the GROWTH of a Roth IRA is also tax free! If you just leave After-Tax money in your 401k, any growth is fully taxable!
Some plans do allow a direct in-plan rollover of your after-tax 401k contributions into the Roth part of the 401k plan. This can be done in addition to your employee contribution of $19.5k (plus the catch-up if you are over 50, which can either be pre-tax or Roth).
Regardless of the specifics, the goal: get more Roth money!
The Mega Backdoor Roth is the best way to do that! If you have a good 401k plan.
How the Mega Roth is Different from the Regular Backdoor Roth IRA
A regular Backdoor Roth IRA is necessary for high income folks because there are income limits on Roth IRA CONTRIBUTIONS. There are no limits on traditional IRA contributions—you just can’t deduct them if your MAGI is too high.
The usual Backdoor Roth IRA is done via a non-deductible contribution to an IRA followed by a conversion to Roth. Since the money is after-tax (non-deduced), there is no tax for the conversion.
There are no income limits for Roth conversions.
The issue with the normal Backdoor Roth IRA is that the source of the contribution is an IRA. This means that Pro-Rata rules applies. The IRS views all of your IRAs as a single account, so you run into tax problems if you try to convert funds that are both pre-and post-tax.
The Mega Backdoor Roth 401k is a 401k so there are no pro-rata issues. It is also done with after-tax money. We don’t call this money non-deductible because you never took it as salary in the first place.
It should also be noted that you will pay social security taxes (if below the wage base) and Medicare taxes on the after-tax contribution. But, of course, if you would have taken the money as salary, you would have paid those as well.
Let’s look at a step-by-step process for how to do a Mega Backdoor Roth.
How the Mega Backdoor Roth Works—Step-by-Step
- Read the plan documents and make sure you can do after-tax contributions
- Figure out your contribution amount (pre-tax or Roth) and determine your match
- Subtract number 2 from the 401k total limit. This is $57k (plus catch up if you are over 50) in 2020
- Elect to do after-tax contributions from your salary. You will pay ordinary income taxes and employment taxes on this.
- If you plan allows in-plan rollovers to Roth 401k, do it! The IRS calls this In-Plan Rollover to Designated Roth Account
- If your plan allows in-service withdrawals, do trustee-to-trustee transfer (not a 60 day rollover) of the after-tax 401k into your Roth IRA
- Well, if your plan doesn’t allow 5 or 6, you might consider adding to your after-tax 401k a few years prior to retirement and then rolling it over when you retire. Here, you would take your pre-tax contributions and growth from the after-tax earnings and roll those over to a traditional IRA, and take your after-tax contributions and roll those over to a Roth IRA
- Don’t forget the Tax forms!
Here are the steps in more detail:
Pictorial Step-by-Step Guide to the Mega Backdoor Roth
Read Plan Documents
How do you know if you have a good 401k plan that allows Mega Backdoor Roths? You are going to have to read the plan documents!
First, find out if you are allowed to make after-tax contributions.
For example, my plan allows 1-60% of before-tax salary to go to the $19.5k employee contribution, and 1-10% of salary to go to after-tax contributions. Remember, the after-tax contributions do not have a limit of $19.5k, they have a limit of $57k MINUS your employee contributions MINUS the employer match.
Next, find out if you can make in-plan conversions or in-service distributions.
Here, the plan documents specify that if I rolled in money from a different pre-tax account (such as another 401k, 403b, or IRA), that I can withdraw it any time. Also, any after-tax voluntary contribution can be withdrawn at any time. Importantly, this is not a hardship withdrawal. This is a withdrawal “at any time.” Hardship Withdrawals have very different issues attached to them which are not addressed here.
Next, find out how much in-service withdrawals cost
Cost of In-Service Withdrawals
Here, there is a $50 charge for any distribution transaction. This means that I want to limit the number of in-service withdrawals I do. Also, it is interesting to note that there is a $125 yearly fee to use this 401k. Not great if you have a small amount invested, but at least it is not a percentage of the investments!
Usually in-plan Roth rollovers are free.
Next, you want to make your after-tax contributions.
Do After-Tax Contributions
This plan allows pre-tax and Roth contributions, in addition to bonus pre-tax and bonus Roth contributions. For the prior, it is usual salary that is deferred, and for the latter, just bonuses are deferred. I’m interested in the after-tax (non-Roth) contribution. Right now it is set at zero percent, as I want to front load the pre-tax contributions during the beginning of the year, as discussed above. Once the pre-tax contributions are maxed out, I will adjust the after-tax contribution to max out the 401k limit. Unfortunately (or I guess fortunately), there is a very generous employer match which limits the amount of after-tax money that can be invested.
Then, see how much money you save in your After-Tax account.
Figure Out How Much After-Tax you have to Convert
I don’t have a screenshot of this prior to rollover, but you can see where it keeps track of my non-Roth amount in a separate account. This is the amount available for Roth rollover to a Roth IRA. Please note the separate account is important. If your plan doesn’t have a separate account for your after-tax contributions, there are pro rata implications I won’t get into here.
Note that you can “go” on this tab on the webpage, but it just takes you to a phone number. At least in my plan, you have to call the custodian in order to do a custodian-to-custodian rollover.
You can also find this information on your monthly statements.
Rollover After-Tax Contributions
Above, in the contribution summary, you can see the after-tax contributions this period and contributions this year. This sum does not include the earnings of the after-tax money, which may be invested aggressively if you want, or you can leave it in cash. If you are going to convert frequently, it is probably best to just leave it in cash until you convert it.
What about the tax forms?
Don’t Forget the Tax Forms
Above, see the 1099-R for tax purposes. This will need to be included when you file your taxes. Note box 1, the gross distribution, that I made some money while the funds were in After-Tax limbo in the 401k. In fact, I made (box 2a) 202.98 or 1.5% on my money. And now I will pay ordinary income taxes on that amount. Box 5 shows the amount of after-tax contribution minus the $50 fee I paid. Nice of them to take that money from my basis! Not. Also note that for whatever reason the pennies don’t quite add up. I can’t figure out why, but I’m not worried about that since the IRS rounds to the nearest dollar.
Let’s look at box 5 for a second.
As you can see, box 5 has a lot of things it can be. Here, it is used to report the after-tax contribution. Box 5, however, is a good example of why people hate the IRS. Try to read all of that and not be confused.
Box 7 is more important though
Distribution Code on the 1099-R
This is important. If this box is checked with an incorrect code, you might be forced to pay taxes again on your after-tax contribution. Note code “G” is checked. This indicated it was a direct (trustee-to-trustee) rollover of a contribution to another qualified plan or an IRA. This indicates there is no 10% early withdrawal penalty as it was a direct rollover to another retirement plan. This, together with the basis from box 5, indicates the money goes tax and penalty free to another acceptable retirement plan such as a Roth IRA.
Finally the money is in our Roth IRA! What next?
Invest in the Roth IRA
Above, you can see the Roth IRA which has a rollover amount equal to the distribution amount. That a nice Roth rollover for my working years! Again, there will be a small amount of taxes paid on the earnings while the money sat in after-tax 401k limbo, but it is nice to have every dollar you can in Roth.
So, that’s a pictorial history of my Mega Backdoor Roth. I hope you enjoyed it! Let’s round out this piece with a few advanced topics.
Advanced Topics in Mega Backdoor Roth
Let’s go over some advanced topics when considering the Mega Backdoor Roth 401k.
And the Solo or Individual 401k
Look closely at the “of the shelf” versions of popular custodians and make sure they have the ability to do a Mega Backdoor Roth if you have a Solo 401k and enough business income. Often time, Roth and after-tax contributions may be more tax-efficient if you are self-employed and qualify for the 199A QBI deduction.
And the 199A QBI Deduction
Depending on the type of industry you are in, and where you are relative to the phase outs, you may want to make pre-tax, Roth, or after-tax contributions in your solo 401k. If you take money out of your taxable income as a pre-tax contribution, you may not get to take the 20% 199A QBI deduction on it! This is a complicated discussion, but has large tax implications. See your CPA.
And the IRS
There are some special rules to follow if you accumulate earnings from your after-tax contributions. If you take a distribution after you separate from service, you can put the pre-tax money and the earnings on the after tax contributions into a traditional IRA, and just take the after-tax contributions into the Roth IRA. This saves you from paying taxes now on the accumulated earnings. It used to be a pro-rata distributions with separation of service, but no more.
In addition, you don’t use form 8606 which is for IRAs. You use form 5498 from your Roth custodian. If you use turbo tax and do a Mega Backdoor Roth, be prepared for some additional headaches.
And maxing out your Roth 401k or Roth IRA first
Again, the Mega Backdoor Roth is just for those who have additional money to save. Max out your Roth or pre-tax contributions first, as well as the traditional Backdoor Roth IRA, etc.
And Roth 401k Contributions
You can do an additional $19.5k of Roth contributions into your 401k plan, if there is a Roth option. This point can be debated and I won’t get into the debate here. Should you do pre-tax or Roth 401k depends on your future and current tax brackets, and future and current sources of income. Among other factors. Personally, I am taking as much deduction as possible as I plan on partial Roth conversions in the future at a lower tax bracket during my Tax Planning Window.
And a Reminder of the Point
The point is to get tax diversification. Load as much money into Roth retirement accounts as soon as possible to take advantage of Tax-Free Growth and Distributions
When NOT to do a Mega Backdoor Roth
Don’t do a Mega Backdoor Roth 401k if:
- You aren’t already maxing out your employee contributions and Backdoor Roth IRA
- If you don’t have in-plan rollovers or in-service withdrawals, you might want to wait until you are 3-5 years out of retirement to start after-tax contributions
- You have better uses for your money
- You will likely need to take distributions from your pre-tax accounts prior to RMDs instead of considering partial Roth conversions
Reasons to Do a Mega Backdoor 401k to Roth IRA Rollover
- Tax diversification is key, especially to control your income in retirement
- Pay taxes now, and have years of tax-free growth in the future
- No Required Minimum Distributions on Roth IRAs (there is on Roth 401k money so you want to roll over your Roth 401k into a Roth IRA prior to RMDs)
- Asset protection (retirement funds are better protected than brokerage accounts)
- Roth accounts are the best accounts you can leave to Heirs