What is a Mega Backdoor Roth?
A Mega Backdoor Roth strategy involves a method that can potentially enable individuals who would otherwise be ineligible to contribute to a Roth account due to income or contribution restrictions to convert specific types of 401(k) contributions into a Roth format, which includes a Roth IRA and/or Roth 401(k).
This strategy can be especially advantageous for those whose income surpasses the direct contribution limits for a Roth IRA. For the tax year 2023, if your income as a single taxpayer exceeds $153,000 or $228,000 as a married-filing-jointly taxpayer, you cannot make direct contributions to a Roth IRA.
How Does a Mega Backdoor Roth Work?
To simplify, the Mega Backdoor Roth strategy involves two main steps: (1) making after-tax contributions to your 401(k) or another workplace retirement plan, and (2) subsequently converting these contributions into a Roth IRA or Roth 401(k). (It's worth noting that not all retirement plans facilitate these steps, and further details on this aspect are provided below.)
Let's delve into these two steps. Firstly, it's crucial to grasp that this strategy commences with a specific kind of contribution, namely after-tax 401(k) contributions. These contributions differ from Roth 401(k) contributions and pre-tax contributions, which are frequently the default choices within a 401(k).
The rationale behind starting with after-tax contributions is their potential to allow you to save more in your workplace retirement plan beyond the annual contribution limit applicable to pre-tax and Roth contributions. Here's a breakdown of this concept:
As evident, if your contributions are limited to pre-tax and/or Roth options, your maximum allowable contribution stands at $22,500 (or $30,000 if you're 50 or older). However, by incorporating after-tax contributions, you could potentially increase your total savings to $66,000 (or $73,500 if you're 50 or older) — albeit with the caveat that any employer contributions would count towards this limit. Nevertheless, after-tax contributions carry certain disadvantages.
One significant drawback is that when you withdraw funds during retirement, any earnings will be subject to taxation at ordinary income rates. Another crucial consideration pertains to the potential impact on employer contributions. If you reach the contribution cap for pre-tax, Roth, and after-tax contributions in a given calendar year, your employer might not be able to make additional contributions. Moreover, depending on your plan's rules, after-tax contributions may not qualify for an employer match.
This leads us to the second phase of the mega backdoor strategy: the conversion of after-tax contributions into a Roth account. If your retirement plan includes a Roth option, you can potentially execute an in-plan Roth conversion, shifting after-tax 401(k) funds into a Roth 401(k). Alternatively, if your plan permits, you may roll over your after-tax contributions into a Roth IRA. The prorated earnings linked to the original contribution can either be transferred to the Roth IRA, incurring taxes, or separately directed to a traditional IRA without tax implications.
Regardless of whether you opt for a Roth IRA or Roth 401(k) conversion, it's important to be aware that you will be responsible for paying taxes on any earnings associated with the conversion (typically, contributions you convert are not subject to taxation, as they have already been taxed). For a thorough understanding of the potential tax implications of this strategy in your specific circumstances, it's advisable to consult a tax professional.
Are you eligible for a mega backdoor Roth?
Whether you are eligible for a mega backdoor Roth depends on the specifics of your workplace retirement plan.
Contribution Limits
When employing the mega backdoor Roth strategy, the amount you can save is subject to restrictions set by the annual limits governing 401(k) contributions. This also hinges on the sum you have contributed through pre-tax and Roth contributions, as well as the contributions made by your employer. As demonstrated in the preceding chart, for the year 2023, individuals below the age of 50 can contribute a maximum of $22,500 through pre-tax and Roth contributions, and the overall contribution cap, encompassing all types, stands at $66,000.
To illustrate, consider a scenario where an individual aged 40 has already made the maximum allowable contributions of $22,500 through pre-tax and/or Roth channels. Additionally, assume that their employer has provided matching contributions amounting to 50%, which is $11,250. In this case, the highest amount they could contribute after-tax to their 401(k) for the year 2023 would be:
$66,000 - $22,500 - $11,250 = $32,250
There are no constraints on the amount you can convert to a Roth IRA within a given year, and there are also no limits on in-plan conversions. However, it's important to note that these conversions can lead to tax implications in the year of conversion, potentially making it less advantageous to convert substantial sums all at once.
Is the Future of the Mega Backdoor Roth in Question?
While the mega backdoor Roth strategy remains permissible in plans that currently support it, there is a chance it could be discontinued in the future.
For instance, the Build Back Better Act, which gained approval in the House towards the end of 2021, aimed to terminate the strategy by forbidding the conversion of after-tax 401(k) contributions into Roth accounts. Although this act ultimately encountered obstacles in the Senate, a similar provision has resurfaced in the recent budget proposal for the fiscal year 2024. Nevertheless, unless legislation prohibiting the strategy is officially enacted, mega backdoor Roth conversions remain feasible within plans that permit them.
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