If you're lucky enough to work at a company with a generous 401(k) policy, you might be able to take advantage of a wonderful investment mechanism called the mega backdoor Roth IRA. Each year, you can contribute a large chunk of money that grows tax free until the end of time. Nice!
Background on the 401(k) Types
I'm going to make a few assumptions about you, the reader. You care about the future and understand the importance of compound interest and exponential growth. You were going to max out your 401(k) regardless of what I tell you, and with your take-home income, you'll probably invest a reasonable portion of that money as well. If these assumptions are untrue, this article probably won't be relevant to you. Otherwise, please read on.
Every year, employees have a legal limit that they can contribute to a 401(k). In 2020 that was $19,500. All of the money for contributions must be deducted from their paychecks. There's a second legal limit for the total amount of money that can enter a 401(k) in a given year. In 2020, that was $57,000. Other sources of money, such as employer matching, do not count towards the first limit, hence the need for a total limit. If you do the math, that means a company can legally do up to a 200% match on 401(k) contributions. If you know of such a company, hit me up.
There are three types of 401(k) plans that most employees might find:
- Traditional (pre-tax)
A traditional 401(k) allows you to contribute money without paying taxes, but upon withdrawal, you're taxed on your original contributions and any growth from investments. A Roth 401(k) taxes in the opposite order. Any income you contribute gets taxed first, but once it's time to withdraw money, everything is tax free. For the most part, you're free to determine how you split your contributions to a traditional and Roth 401(k). Otherwise, you're free to enjoy a tax-advantaged investment account.
Once you've maxed out your employee contribution, some employers allow after-tax 401(k) contributions, which don't count as part of the employee contribution limit. (It will still count as part of the total 401(k) limit.) If you choose to use an after-tax 401(k), any contributions will be taxed, and when you withdraw money, you'll have to pay capital gains tax on the growth of your investments. Astute readers might now wonder: how is an after-tax 401(k) better than a normal personal investment account? I can't give you a good answer, at least on a surface level. If anything, it seems worse than a generic taxable investment account.
|Taxed on deposit?||Taxed on withdrawal?||Taxed on growth?|
The Roth IRA Rollover
The mega backdoor Roth IRA is a strategy that involves rolling over your funds from an after-tax 401(k) to a Roth IRA. Unlike an after-tax 401(k), a Roth IRA will not be taxed on capital gains. Therefore, the point of using the mega backdoor Roth IRA is to legally exceed the employee contribution limit for 401(k)s while having all of the money go into tax-advantaged accounts.
There are a few limitations to the mega backdoor Roth IRA rollover, however:
- Your employer's retirement plan must allow after-tax 401(k) contributions.
- Your employer's retirement plan must allow rollovers (or in-service distributions) from your 401(k) before retirement.
- The total contribution among all the aforementioned retirement accounts and employer matching cannot exceed the legal 401(k) limit.
- You must make enough money to contribute to the after-tax 401(k) and don't need the extra cash. (Were you planning to invest over $20,000 this year? If not, this might not be the right choice.)
If none of these limitations are a problem, you're ready to use the mega backdoor Roth IRA. After maxing out your 401(k), continue to contribute to the after-tax 401(k) and roll over the funds to a Roth IRA.
Steps to Using the Mega Backdoor Roth
Now that we've covered the mechanics and motivations of the mega backdoor Roth, let's dive into a simple guide on what to actually do.
- Open up a Roth IRA. I highly recommend that this account be with the same broker that handles your 401(k).
- Max out your annual employee 401(k) contribution. Allocate the money in a traditional or Roth 401(k) however you'd like.
- Send additional contributions above the employee contribution limit to your after-tax 401(k).
- As soon as any money is contributed to the after-tax 401(k) account, roll the funds over to your Roth IRA. (If you're using Vanguard, there might be an option for the platform to do this step automatically.)
- Stop contributing to your after-tax 401(k) once your total contributions have reached the annual 401(k) total contribution limit. (Remember this includes any money from employer matching.) Most brokers, such as Vanguard, will automatically stop your contributions at this point.
- Resume your contributions next year.
I love money, and I hate taxes. If you feel the same way, using the mega backdoor Roth is a great way to not pay taxes. As a disclaimer, I'm not a retirement expert, nor am I a fiduciary. Double check your retirement plan, do your own research, and think for yourself.
Enjoy your tax-free growth!