A Mega Backdoor Roth is a conversion strategy that allows you to save a much higher amount in your Roth IRA than you are allowed to through direct contributions. Using a mega backdoor Roth is also a way that you can contribute to a Roth IRA if your income is above the phaseout limit and you no longer qualify to contribute directly to a Roth IRA.
The basic idea is that you first contribute to your retirement plan and then convert a portion of the plan by rolling your money into a Roth IRA.
In this article I’ll explain what a mega backdoor Roth IRA is and how you can use it make significant improvements in your retirement.
Contributions to your Retirement Plan
The first step in a mega backdoor Roth is to contribute to your retirement plan. This strategy works for 401(k), 403(b), and 457 plans.
The type of contribution you make is important, and is a key element of this strategy. Retirement plan contributions can be one of three types:
- Traditional or Pre-Tax: If you make traditional contributions to your retirement plan then you won’t owe income taxes on that amount for the current year. You will, however, have to pay income tax on distributions when you retire. You are probably very familiar with this type of contribution.
- Roth: You still owe income tax on any Roth contributions you make in a given year, but won’t owe income tax when you withdraw the money in retirement. This includes the growth. Again, a very well known type of contribution.
- After-tax: These are similar to a Roth contribution in that you don’t get to deduct this amount from your income. However, there is a big difference between after-tax and Roth contributions when you retire and withdraw the money. The growth on after-tax contributions is taxed when you withdraw it.
Here is where we dig in on the mega backdoor Roth. After-tax dollars are contributions that you make to your retirement plan for which you don’t get a deduction. That’s the same initial tax treatment as a Roth contribution. However, after-tax contributions don’t get the same favorable tax treatment on the back end when you withdraw the money in retirement.
So why make an after-tax contribution?
You are limited on the amount you can contribute to a retirement plan each year. For 2019, you can contribute $19,000.
There’s a little more to it than that though. That $19,000 contribution limit really applies to traditional and Roth contributions. Although most people will leave it at that, there is a big planning opportunity if you are financially able to contribute beyond that.
This is where the after-tax contributions come in. Suppose you have a traditional 401(k). You would be allowed to contribute $19,000 (plus an additional $6,000 “catch-up” if you are 50 or over) and receive the current year tax deduction. You can still contribute more, those contributions will simply be after-tax and not get the same favorable tax treatment as Roth or Traditional contributions.
So how much more can you contribute?
There is a total amount that can be added to a retirement account from all sources each year. This number is a backstop that you cannot go over without incurring a tax penalty. For 2019, the annual additions limit on a 401(k) is $56,000, or $62,000 if you are 50 or older and make the catch-up contribution. So, in addition to the $19,000 traditional or Roth contribution, another $37,000 can be added to your account.
Your employer probably matches a portion of your contribution as well. That amount counts toward the $62,000 total.
As an example, suppose you are over 50 and make the maximum contribution of $25,000 which consists of the $19,000 contribution limit plus the $6,000 catch-up contribution. If your employer also contributes $10,000 to your account for the year then you have added $35,000 to your account.
You still have $27,000 of your annual additions limit left. Since you have already made the maximum contribution allowable for traditional or Roth contributions you’ll have to make an after-tax contribution.
The after-tax contribution is what you will ultimately convert into a Roth IRA.
The Roth Conversion
Next, you’ll convert the after-tax contribution.
If you don’t already have one, you’ll need to open a Roth IRA. Then, roll the after-tax contribution to the Roth IRA. Your employer will have to allow for in-service distributions in order to do this. If you aren’t sure, talk to HR. They’ll probably have the forms or direct you to an online portal to fill them out. Be careful that you only roll the after-tax amounts into the Roth. You’ll need to leave the pre-tax dollars in your plan or roll those into a traditional IRA.
It may still make sense to plan for a mega backdoor Roth even if your employer doesn’t allow for in-service withdrawals. If you leave in the future, you’ll be able to roll your after-tax contributions into a Roth IRA then.
Remember in the example above your after-tax contribution is $27,000?
That’s right. You just added $27,000 to a Roth IRA. That’s why this is a “mega” backdoor Roth. Compare that to a standard backdoor Roth IRA where you make after-tax contributions to a traditional IRA and then convert. IRA contribution limits are significantly less than the additions limit on a qualified retirement plan so you won’t have as much to convert.
What About Taxes?
You may be wondering about taxes. Normally when you do a Roth conversion you have to pay taxes on the amount converted. However, realize in the case of a backdoor Roth, including a mega backdoor Roth as outlined here, you already paid taxes. You aren’t converting pre-tax dollars into Roth dollars. Therefore, there isn’t an income tax implication.
Mega Backdoor Roth Benefits
The main benefit of a mega backdoor Roth over a standard backdoor Roth is that you can contribute a much larger amount. Yes, there a few more steps to go through but it really isn’t that difficult.
If you are over the income phase-out limit for a Roth IRA, then doing a mega backdoor Roth conversion will allow you to still save Roth dollars. This will give you some tax diversification in retirement.
This strategy can be especially helpful if you plan to retire early and are building a Roth IRA conversion ladder to fund your retirement before you turn 59.5.