Utilizing the “mega backdoor” strategy with a Roth 401(k) option at work:
The Roth 401(k) is a retirement savings vehicle that offers unique advantages compared to traditional 401(k)s. One of these advantages is the ability to make after-tax contributions, which can be particularly beneficial for high-income earners who have already maxed out their regular Roth IRA contributions.
However, there is an even more advanced strategy called the “mega backdoor” that allows individuals to contribute significantly more than the standard contribution limits to their Roth 401(k). In this article, we will explore how this strategy works and when it makes sense to utilize it.
Firstly, let’s understand how the mega backdoor strategy differs from regular after-tax contributions. With a typical after-tax contribution, you can contribute up to the annual limit set by your employer (which is currently $19,500 in 2021), regardless of whether you’ve reached your overall contribution limit ($58,000 in total for those under 50).
On the other hand, with the mega backdoor strategy, you can contribute beyond these limits using what are known as “non-Roth elective deferrals.” These additional contributions are made on an after-tax basis and are subject to certain rules and limitations imposed by employers.
To take advantage of this strategy, your employer must allow non-Roth elective deferrals and permit in-service withdrawals or conversions. Not all employers offer this option, so it’s essential to check if it’s available within your retirement plan.
Once you confirm that your employer does allow for non-Roth elective deferrals and in-service withdrawals or conversions, here’s how the process typically works:
1. Maximize regular pre-tax and/or Roth contributions: Before considering mega backdoor contributions, ensure you’re maximizing your regular pre-tax or Roth contributions up to the annual limit ($19,500 for those under 50).
2. Contribute to the after-tax portion: After reaching the regular contribution limit, contribute to the after-tax portion of your Roth 401(k). This is where you can make additional contributions beyond the standard limits. Be aware that there may be an overall contribution limit imposed by your employer (usually $58,000 in total for those under 50).
3. Request an in-service withdrawal or conversion: Once you’ve made your after-tax contributions, request an in-service withdrawal or conversion from your plan administrator. This allows you to move the after-tax funds into a Roth IRA while leaving any earnings within the pre-tax and/or Roth portions of your 401(k) untouched.
4. Pay attention to taxes: It’s important to note that when converting the after-tax funds into a Roth IRA, you’ll need to pay taxes on any gains made during this process. However, since these funds were already taxed when contributed as part of non-Roth elective deferrals, only earnings will be subject to taxation.
5. Enjoy tax-free growth potential: By moving the after-tax funds into a Roth IRA, you can take advantage of tax-free growth potential and enjoy qualified distributions during retirement without paying taxes on them.
Now that we understand how the mega backdoor strategy works let’s discuss when it makes sense to utilize it.
This strategy is most suitable for high-income earners who have maxed out their regular Roth IRA contributions ($6,000 for those under 50) and still want to save more towards their retirement goals with tax advantages.
Additionally, if you expect significant future income growth or anticipate being in a higher tax bracket during retirement due to investment success or other factors such as required minimum distributions (RMDs), utilizing the mega backdoor strategy can help mitigate potential future tax burdens.
Furthermore, individuals who have more disposable income available for savings may find this strategy appealing because they can effectively contribute larger amounts towards their retirement accounts than what traditional limits allow.
It’s important to keep in mind that each individual’s financial situation is unique, and the decision to utilize the mega backdoor strategy should be made after careful consideration of various factors such as current and future income levels, tax implications, retirement goals, and overall financial plan.
In conclusion, the mega backdoor strategy can be a powerful tool for high-income earners looking to maximize their retirement savings with additional tax advantages. However, it’s essential to ensure that your employer offers this option within your 401(k) plan and comply with any rules or limitations imposed by them. As always, consulting with a qualified financial advisor or tax professional can provide personalized guidance based on your specific circumstances.