By Dan Federman, CFP®
If you are already maxing out the salary deferral portion of your 401(k), and you have excess cash flow that you can divert into retirement savings, consider taking advantage of the “mega backdoor Roth conversion” strategy if it is available in your 401(k).
To find out if this option is available, simply call your 401(k) provider and ask, “Am I allowed to make after-tax contributions to my 401(k) plan?” If the answer is “yes,” you may be able to create a mega Roth account, allowing you to substantially increase your retirement savings.
Let’s review how this works by explaining the different types of 401(k) contributions.
What Choices Are Available in My 401(k) Plan?
In traditional 401(k) plans, employees generally have three options:
- Pre-tax contributions are deducted from your paycheck, help lower your tax bill today, and grow tax-deferred until you make a withdrawal in retirement, at which time the distribution will be taxed as ordinary income.
If there is an “employer match,” the employer’s contributions are also pre-tax and are in addition to the annual employee contribution limit (in 2020, $19,500, plus $6,500 catch-up for those over 50).
- Roth contributions are made with after-tax money. The contributions grow tax-free, and all earnings growth can be withdrawn tax-free at the time you make withdrawals in retirement.
- After-tax contributions, like Roth contributions, are made with money you’ve already paid taxes on. Unlike the Roth, earnings grow tax-deferred and will be taxed upon withdrawal. The principal, however, is not taxed upon withdrawal.
How Much Can I Contribute to My 401(k) Plan?
As defined by the IRS, the annual elective deferral limit on 401(k) contributions, in 2020, for employees is $19,500. Anyone 50 or over is eligible to make an additional catch-up contribution of $6,500.
Employers may also contribute. However, there is a $57,000 limit on combined employer and employee contributions ($63,500 for those eligible for a catch-up contribution).
Pre-Tax or Roth?
Determining whether to contribute pre-tax vs. Roth comes down to a choice of paying taxes now or later. If you’re in a low tax marginal tax bracket such as 12%, there may not be much tax benefit to contributing to the pre-tax account. If you’re in a higher tax bracket, then you may want to take advantage of the tax deduction of a pre-tax contribution.
What Is the Mega Backdoor Roth Conversion?
The mega backdoor Roth conversion is the answer to “What can I do if I’m already contributing the maximum $19,000 (or $25,000 if 50 or older by year-end) and I’d like to contribute more?”
Let’s say Brian, age 47, married, earns $175,000 in compensation from XYZ company. He contributes $19,500 in his pre-tax 401(k). In addition, he receives a 4% employer match, totaling $7,000. At this point, the combination of his employee contributions and employer contributions totals $26,500, but the IRS allows a maximum of $57,000 altogether.
To make up the difference, Brian contributes an additional $30,500 into the after-tax account in his 401(k) plan and elects to immediately convert the $30,500 contribution to the Roth 401(k) account.
As a result, Brian has essentially made a $30,500 Roth 401(k) contribution in one year. This is much bigger than the annual Roth IRA contribution of $6,000 allowed by the IRS ($7,000 if 50 or older by year-end). This is why the strategy is known as a “mega” backdoor Roth conversion—the amounts available to “contribute” to a Roth are substantially larger than the Roth IRA limit.
Can I Still Make a Regular Backdoor Roth IRA Contribution?
Yes. Continuing with our example above, if Brian’s household income exceeds the income eligibility limits to contribute to a regular Roth IRA, Brian can make a non-deductible $6,000 contribution to a traditional IRA and immediately convert the funds to his Roth IRA.
As long as Brian has no other IRA balances at the time of conversion, this will be a tax-free event. This requirement includes SEP-IRA and SIMPLE IRA accounts.
Is There Anything Else I Need to Know?
If your 401(k) plan allows after-tax contributions but does not allow the conversion to the Roth account, the plan may allow for “in-service” distributions. If so, you may be able to roll over the after-tax contributions to a Roth IRA once per year.
When you next meet with your team of advisors for financial planning and tax advice, discuss whether the mega backdoor Roth is an option you have and if it’s right for you.
Disclaimer: This is not intended to be tax advice. Always consult your CPA before taking any action that has tax implications.
Schedule a complimentary meeting with a wealth advisor to discuss your personal situation.
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