Admittedly, the “mega backdoor Roth” is a mouthful of a term. Not to be confused with the backdoor Roth IRA, it is a strategy that allows high-income earners to maximize contributions to their employer retirement plan.
In this article, we'll explain the mega backdoor Roth strategy step-by-step, discuss how to implement it correctly, and reveal the tax trap you need to avoid if you want optimal results.
Step One: Making Regular 401(k) Contributions
Employees who participate in a 401(k) retirement plan can defer a portion of their income to invest for their future.
In 2024, the IRS allows employees to contribute up to $23,000 to a Traditional or pre-tax 401(k) or Roth 401(k), plus an additional $7,500 “catch-up contribution” for those 50 or older.
To make retirement plans more attractive, more companies now allow employees to make additional contributions to their 401(k) plan in the form of after-tax contributions.
Before this conversation gets confusing, think of your 401(k) as a retirement savings tool made up of three different buckets:
- Traditional 401(k): These are pre-tax contributions, meaning no taxes are withheld when making the contributions. The growth is then tax-deferred until the funds are distributed, ideally at retirement, at which time they are taxed as ordinary income.
- Roth 401(k): These are made with after-tax dollars and grow tax-free, meaning no additional taxes are owed at the time of distribution.
- After-Tax 401(k): These contributions are a blend between the Roth (401k) and the Traditional 401(k). Your contributions are taxed going in, and the growth will be taxed when distributed unless you use the mega backdoor Roth strategy.
If you want to save more in your employer retirement plan in a tax-efficient way, the mega backdoor Roth strategy may be for you.
Most people are only familiar with the Traditional or Roth 401(k), perhaps because their regular contributions don't exceed the annual contribution limits.
High-income earners could quickly reach that limit, making that third "bucket", the after-tax 401(k), a great resource.
It is also good to know that the annual contribution limits apply across your Traditional and Roth 401(k) and multiple employer plans.
For example, if you made contributions to more than one retirement plan in the same year, perhaps due to a job change or working multiple jobs, the sum of your contributions across both Traditional and Roth accounts cannot exceed the annual limit. (These limits are adjusted each year, so use this link as a reference to make sure you're up to date on the latest numbers.)
Employer contributions and matches do not count toward the annual limit.
Step Two: Making After-Tax Contributions
If you’re a high-income earner with ambitious savings goals and excess cash, you may want to consider contributing more after maxing out the annual limit. In this situation, the after-tax 401(k), if available through your employer plan, could enable you to triple your savings.
Contributing with after-tax funds allow employees to contribute up to $69,000 including matching contributions from their employer, or $76,500 for those 50 and older.
For example, if you contribute $23,000 in 2024 (or $30,500 if older than 50), and your employer pitches in an additional $5,000, you still have room to contribute an extra $41,000 into the after-tax 401(k).
If you don't get an employer match, you could contribute an additional $46,000 into the after-tax account.
While the after-tax feature allows you to save a lot more for retirement, it is not a tax-efficient tool by itself, since the growth in your contributions will be taxed as ordinary income at the time of distribution.
At Plancorp, we prioritize minimizing our clients' tax liability whenever possible. This is where knowledge and the correct application of the mega back door Roth strategy could save you a lot.
Step Three: Implementing the Mega Backdoor Roth
To prevent the growth in your after-tax 401(k) from being taxed in the future, you can "convert" those contributions to your Roth 401(k) account. This is the mega backdoor Roth strategy.
This mechanism can be automated in many retirement plans, allowing you to rollover contributions immediately into your Roth account and enjoy tax-free growth.
If you decide to use the after-tax "bucket" of your 401(k), take the time to implement the mega backdoor Roth strategy to grow tax-efficiently.
Participating in the after-tax 401(k) has its advantages and disadvantages. The main advantage, as we have exposed already, involves taxes.
Let's say you contribute $46,000 annually to your after-tax 401(k) and make in-plan Roth conversions. At retirement when you withdraw the funds, you wouldn't owe taxes.
Contrast that with investing the same $46,000 annually into an individual taxable investments account. You would be subject to annual taxes on any interest or dividend income, plus capital gains taxes that could range anywhere from 0-23% for long-term positions or up to 37% for short-term positions, whenever you sell your investment.
Compared to a taxable account, the potential tax savings of using the mega backdoor Roth strategy could amount to tens, or even hundreds of thousands of dollars over time, especially if implemented early to make time for all that tax-free growth to compound.
One of the main disadvantages of participating in the after-tax 401k is the lack of flexibility. Your 401(k) is a retirement savings tool, and $46,000 in additional annual contributions to your plan is a lot of money to lock away until you retire.
What if you need the extra cash for a down payment on a home, to invest in your children's education, or to indulge in a nice vacation?
If you don't have other cash available, you could pull some money out of your 401(k), subject to penalties and taxes, but that would defeat the purpose of using the after-tax 401(k).
In contrast, if you sell investments in your taxable account, you can pursue your goals without facing penalties.
Deciding if the mega backdoor Roth strategy is right for you today requires a thorough examination of your current financial situation, cash flow, savings goals, and life goals which your wealth manager can help you analyze.
Incorporating IRAs
The above method is a preferred way to implement the mega backdoor Roth strategy because it is straightforward and requires a one-time setup.
There is an alternative way to implement it, however. While we don't prefer this method at Plancorp, we believe it is important for investors to be well-informed and know their options.
The alternative involves converting your after-tax contributions into a Roth individual retirement account (Roth IRA) outside of your employer plan, instead of into the Roth 401(k) offered by your employer.
Rules for converting to a Roth 401(k) vary from company to company, but it is typically easier than converting to a Roth IRA because it can be automated.
Conversions from an after-tax 401(k) into a Roth IRA cannot be automated, which means that every time there is a contribution, you have to proactively contact your plan administrator to request the conversion into the Roth IRA.
Depending on your payroll frequency, you may need to contact your plan administrator several times per month.
If you don't have a Roth IRA to begin with, you need to take the time to set that account up with the provider of your choice.
If you decide to put in the extra work and use a Roth IRA, know that your effort could be rewarded. There are more favorable rules when withdrawing money from a Roth IRA than a Roth 401(k).
In particular, you can withdraw your mega backdoor Roth IRA contributions after five years without penalty. This does not apply to the growth.
While this is a good perk to be aware of, we don't necessarily recommend it. Pulling money out of a Roth IRA defeats the purpose of saving for retirement. Plus, there is no way to put the money back in, so you take away the ability of those funds to grow tax-free permanently.
Also, savings in a Roth IRA or Roth 401k are not subject to required minimum distributions like funds in a Traditional IRA or Traditional 401(k), which gives you more autonomy to plan an efficient tax strategy for your retirement withdrawals.
Avoid This Tax Trap
To implement the mega backdoor Roth strategy in the most tax-efficient way, you should first make sure there is no existing balance in your after-tax 401(k).
An existing balance with associated growth can cause unexpected tax bills after performing a mega backdoor Roth conversion.
The IRS's Pro-Rata rule applies in this situation, making the growth portion of the balance in the after-tax account taxable at the time of the conversion into the Roth account.
You can avoid this tax implication by setting up automated Roth conversions from the get-go as you establish your after-tax contributions.
If your after-tax balance is significant and you still want to explore conversions into Roth for tax-free growth, work with your wealth manager and a tax professional on a proactive tax-efficient strategy to achieve that goal.
Next Steps
If you are a high-income earner with extra cash flow to save toward retirement, the mega backdoor Roth strategy is worth exploring.
That said, we don’t recommend planning for it in isolation. If you get other tax-advantaged employer benefits, such as a non-qualified deferred compensation plan, you will want to analyze the optimal amount to contribute to each.
Coming up with the best strategy to maximize your employer benefits and minimize taxes can be overwhelming. The good news is that you don't have to navigate those complicated decisions alone.
Work with a wealth manager to develop a comprehensive financial plan, review your tax projections, and evaluate your employer benefits.
Then, decide how to integrate strategies like the mega backdoor Roth with other elements of your financial future like Social Security benefits, retirement income from IRA and HSA accounts, and your taxable investments.
Remember that in personal finance, things are always nuanced. To thrive, you need a partner that understands you personally.
If you are a high-achiever looking to elevate your results and delegate the complexities of your finances, our 2-minute financial analysis is a great place to start.
Ready to put the Mega Backdoor Roth Strategy into action? Download our FREE helpful worksheet today to see if it's right for you, crunch some numbers, and learn how to implement for serious tax savings!
