Most of us would have heard of backdoor Roth. I have spoken about it as well in my other article here. It is an awesome strategy for people who cannot invest in Roth due to high income. The challenge with that strategy is that it still allows a person to put only $5,500 a year to Roth. Wouldn’t it be great if we can figure out a way to bypass this limitation? After all, this Roth investment limit has not changed for last several years.
There is one another backdoor to Roth that is not as widespread or commonly known but it does allow you to save up to $ 36,000 a year in Roth IRA. Yes, it is not a misspelling, you can save up to 36 Grand a year in Roth IRA and then never pay tax on the growth from it. This strategy is not for everyone, but those who are in a position to use it can reap the benefits of the most beneficial backdoor mechanism available. It is supercharged backdoor Roth strategy also commonly known as Mega-Backdoor Roth.
Now, whether you can use it and how it works is a bit complicated so first, let’s clear a few concepts:
Types of 401K contributions.
There are four different types of 401K contributions that are allowed in a 401K account. These are:
- Pre-Tax Employee Contributions – These are the most common contributions in 401k accounts. The amount paid is pre-tax, i.e. there is no tax charged on the contributions. The growth is Tax-Deferred and when withdrawals are done, they are taxed as ordinary income.
- Employer contributions – Most employers do a match to the money invested in 401K accounts. These funds are also pre-tax and withdrawals are taxed as ordinary income.
- Roth 401K contributions – These are post-tax contributions that some 401K plans allow. These allow investors to pay tax upfront on 401K contributions but the growth is tax-free. i.e. there is no tax charged when money is withdrawn in retirement. Between the Pre-Tax and Roth 401K (together), an employee is allowed to invest $18,500 in 2018.
- Post Tax Employee Contributions – Now, these are the important ones. These are not Roth 401K contributions but a contribution above the 18,500 limit of pre-tax and Roth. The contributions are tax paid, the growth is tax-deferred and the withdrawals on growth is taxed but the contribution is not. These are not very common but if they exist, you can deposit 55,000 – contributions in category 1-3 above. So, taking a hypothetical scenario where you invest 10K to 401K and your employer matched it with another 10K, then you can deposit up to 35K Post Tax in your 401K.
Now, once you are clear on different kinds of 401K contributions, let’s look at what is needed to use this crazy Mega Backdoor Roth strategy. This strategy works for you only if you satisfy the following scenarios.
- You have a 401K account that allows Post Tax Employee Contributions a.k.a. the fourth type in the list above. This is mandatory.
- Your plan allows you to take an in-service withdrawal/rollover. If this is not allowed, you can still do the Mega Backdoor but can do it only when you leave your job.
- You can save more than 18 K a year for retirement. If you cannot exceed 18K savings goal, you are better off with a Roth 401K and not bother with this.
How to achieve Mega Backdoor Roth:
First, let’s get the legality of this approach out of the way. IRS published their 2014.54 notice in 2014 providing statutory backing to this approach. This notice is terse and full of legalese but there are a few examples that are clear. Thankfully, IRS went a step ahead and clarified it in a language as simple as it could be here.
Now, to work on this, the first step you need to do is start saving some money in Post-Tax bucket. Let’s assume that you earn 100 K annually and are saving 18% in traditional 401K and 10% in post-tax contributions. The company match was 6K (100% match for first 6%). During the year, the amount invested in your 401K falls into the following buckets:
|Contribution Category||Contribution Amount|
In the above scenario, you can go all the way up to 31 K for Post-Tax contribution (total less than 55 K). Now, let’s assume at the end of the year, the market went up and there were gains of about 10K in total across all three accounts split as (5K in the Pre-Tax bucket, 3K in Post-Tax contribution bucket and 2K in company match bucket). Your total portfolio becomes:
|Contribution Category||Contribution Amount||Growth|
Plans that allow direct 401K to Roth Rollover
If your plan allows a direct rollover from your 401K to IRA and Roth accounts, it makes life very easy. The transfer you need to do would go as:
- Rollover all Employee Pre-Tax contribution and growth to traditional IRA
- Rollover all Company Match and Growth to traditional IRA.
- For the Post Tax bucket:
- Rollover all of 10 K contribution to Roth IRA
- Rollover the growth if possible to Traditional IRA.
Some plans may not allow you to move the growth to Traditional IRA and in that case, you may have to pay tax on it and move it to Roth IRA.
That is pretty much it and you are all set.
Plans that don’t allow direct 401K to Roth rollover.
There are some plans that force you to roll over everything to a traditional IRA. This makes things a bit tricky esp. if you have other IRA plans historically. What you do is:
- Rollover all six components into a Traditional IRA
- Do a backdoor Roth of 10K (Post Tax contribution) to a Roth IRA
Transfer the rest of the funds back into 401K as a rollover. If you have any other IRAs, you need to roll them into a 401K as well. This needs to be done before 31st of December of that year to ensure the Pro-Rata rule doesn’t get applied to you.
Plans that don’t allow 401K to Roth or a Roll-in of IRA
If your plan doesn’t allow you to transfer money directly from 401K to Roth IRA and doesn’t allow you to roll over any existing IRA to the plan, then your plan is designed specifically to prevent Mega backdoor Roth. You can still pursue the strategy but you need to pay taxes on all of your pre-tax income and all of it would go to Roth IRA. i.e. in the above scenario, you will move all of 44 K to Roth IRA but depending on your tax bracket, would have to pay tax on 34 K of pre-tax money.
If you are planning to switch jobs in next few years, you may still want to accumulate post-tax money in your 401K and do the rollover after you switch. After the Rollover, you would have to move the rest of the funds in new company’s 401K to avoid Pro-Rata rule.