Mega Backdoor Roth Contributions–A Compelling Savings Technique for Some 401(k) Participants

At Bragg, we are always looking for opportunities to help our clients save (and invest) additional money. We often hear “I wish I had a large Roth IRA!” from clients in or nearing retirement.  Over the long-term, the Roth offers several key advantages over pre-tax savings to the Traditional IRA or 401(k).  Benton Bragg provides more detail on what a Roth is, ways to get money into them, and their planning benefits in his article Roth IRAs for Everyone.  As you will read, your income level may exclude you from being eligible to make contributions to an individual Roth IRA, and income taxes may discourage you from making a conversion to a Roth IRA.  This can make it difficult to accumulate larger Roth balances during your working years.

One lesser-known option for some, though not all, clients is a “mega backdoor Roth contribution.”  This savings technique allows one to contribute after-tax dollars to your 401(k), above and beyond the regular contribution limits, and then convert those after-tax dollars to a Roth bucket.  Not only does this strategy increase one’s tax-advantaged savings, but it also provides the benefit of tax diversification when accessing the funds during retirement.

What is a Mega Backdoor Roth Contribution?

Many 401(k) savers are aware of the annual employee contribution limits.  For 2021, those limits are $19,500 for those under 50 years of age, with an additional “catch-up” contribution of $6,500 for those age 50 and older.  But the IRS limit on total 401(k) contributions is $58,000 for 2021 ($64,500 for those age 50+).  This total includes the employee contributions plus employer contributions.

For example, let’s assume you max out your employee contribution at $19,500 and your employer contributes an additional $10,000.  This leaves you with the potential ability to contribute another $28,500 on an after-tax basis to the plan, assuming your employer allows for it.  Please remember, these additional contributions would be after-tax contributions, NOT Roth 401(k) contributions.  The next step would be moving these after-tax contributions into a Roth “bucket,” where they grow tax-free.

Who might benefit from Mega Backdoor Roth Contributions?

• You are already maxing out your 401(k) contributions.
• You have the ability to put away more of your income towards your retirement. Likewise, you have ample liquidity in non-retirement accounts should a cash flow need arise.
• Due to your income, you cannot deduct contributions to a Traditional IRA or make contributions to a Roth IRA. See the 2021 limits and income phaseouts at the bottom of Jen Muckley’s article on 2021 IRA Inflation Adjustments.
• Your employer allows after-tax contributions into the company 401(k) and lets you convert those contributions into a Roth bucket—either intra-plan to the Roth 401(k) portion or via in-service distribution to a Roth IRA.

How Do I Complete a Mega Backdoor Roth Contribution?

Step 1:  Determine if your employer plan:

1. Allows for after-tax contributions. This will enable you to make additional after-tax contributions up to the current IRS limit.
2. Allows for in-plan Roth conversions or in-service distribution/non-hardship withdrawals. These provisions would allow you to subsequently transfer the after-tax contribution dollars either to the Roth 401(k) section of the plan or to a Roth IRA. The ability to do this maximizes the benefits of this strategy, as it allows the dollars to grow for a longer period within the Roth account, where both contributions and earnings would come out free of tax in the future.

NOTE:  What if the in-service distribution (to a Roth IRA) or in-plan conversion (to the Roth 401(k) section of the plan) are not available? The contributions themselves still would not be taxed again upon distribution and could be later rolled into a Roth, but the earnings on those contributions would be considered pre-tax and taxed as ordinary income.  While the tax benefit is not as great under this scenario, it is nevertheless worth considering because it allows you to put away more money towards your retirement that will grow tax-deferred.  The chart below illustrates how different plan contributions are treated for tax purposes.

Step 2:  Max out your employee contributions up the annual limit ($19,500, or $26,000 for those age 50+ in 2021).

Step 3:  Make after-tax contributions to the plan.  As shown in the example earlier, this amount would be the difference between the IRA limit on total 401(k) contributions (for 2021; $58,000 for those age 49 or younger and $64,500 for those 50 or older) and the sum of your employee maximum (see Step #2) and employer contributions.

Step 4:  Move the after-tax contributions (see Step #3) to a Roth bucket.  As we show in the chart above, this step can add significant future tax savings as you are preventing the potential investment growth on these contributions from being taxed again.  It’s also important to execute this step relatively soon after the after-tax contribution is made, as any earnings on the contributions would be considered taxable as income.  This step may be accomplished by:

1. An In-Plan Conversion to the Roth 401(k) side of the plan, or
2. An In-Service Distribution to an outside Roth IRA in your name. (Please note, however, that in our experience, it can be rare to find a company plan that allows both after-tax contributions and in-service distributions.)

As mentioned above, this savings strategy allows for future tax diversification.  We strongly favor the idea of diversifying the tax nature of your assets earmarked towards retirement.  Assets in Pre-Tax, Roth, and After-Tax accounts will give you added flexibility when drawing on your investments to meet your needs in retirement.  For those with legacy goals, Roth savings also create an asset with greater tax-efficiency to pass on to heirs.  The mega backdoor Roth contribution can be used to boost your Roth balances.

All of this said, please do not fret if your employer plan does not allow for after-tax contributions.  The mega backdoor Roth contribution is simply one option for tax-advantaged saving towards retirement. There are additional savings alternatives that we are happy to discuss, such as regular IRA and employer plan contributions, backdoor Roth IRA contributions, and Health Savings Account contributions (see Mary Lou Daly’s article discussing the triple-tax advantage of HSAs).  As always, please reach out to us at Bragg to discuss your circumstances and planning needs.

This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.