Time to Read: 7 Minutes
Maximizing retirement savings and devising strategies to keep taxes low are the cornerstones of building wealth. But with relatively low limits on 401(k) savings, how should high earners invest excess cash? There’s an extremely productive strategy that can turn your 401(k) into a vehicle for saving above the income limits and creating tax-free distributions later. It’s called the Mega Backdoor Roth 401(k).
Let’s Start by Explaining the Foundation: The Backdoor Roth IRA Explained
The Mega Backdoor Roth 401(k) is a spin-off of the better-known Backdoor Roth IRA strategy, which is a technique used by high earners to make Roth contributions even if they are above the IRS’s income limits. To make understanding the Mega Backdoor Roth 401(k) easier, we’re going to review the Backdoor Roth IRA first. It takes place solely inside an IRA, not a 401(k), and is predicated on two key differences between traditional IRAs and Roth IRAs: taxation and income limits.
- Timing of Taxation – Similar to Roth 401(k) contributions, Roth IRA contributions are made with after-tax dollars, meaning you pay income taxes on the money before putting it into the account. The money then grows tax-deferred inside the IRA and is withdrawn tax-free in retirement.
- Income Limits – There are limits on whether you can contribute to a Roth IRA. In 2021, you can only contribute to a Roth IRA if you earn less than $140,000 as a single filer, or less than $208,000 as a joint filer. Traditional IRAs do not have income limits but there are limits on getting a tax deduction for contributions.
For individuals who seek the tax benefits of Roth IRAs, but earn an income above the IRS’s limits, they have the option to implement a Backdoor Roth IRA. Here is how it works:
Step 1: Open and make a contribution to a traditional IRA. The maximum amount you can contribute for 2021 is $6,000, or $7,000 if you are age 50 or older. If you make too much income, you will not get a tax deduction for your contribution.
Step 2: Convert your traditional IRA to a Roth IRA. Do this conversion right away, otherwise you will have to pay taxes on any gains accrued inside the traditional IRA.
Step 3: Pay taxes on the contributions once tax season rolls around if you received a deduction on the initial contribution. Essentially you are paying back the tax deduction you received when initially contributing to your traditional IRA. Then, with each tax year, you rinse and repeat, making sure to close each traditional IRA each year so there is no residual growth inside a traditional IRA.
The Backdoor Roth IRA strategy is not for everyone and can have lasting negative tax implications if done incorrectly. For example, this strategy does not work well if you already have an existing traditional IRA open. This is because the pro rata rule states that contributions and earnings cannot be separated once inside a traditional IRA. In other words, if you already have gains inside a traditional IRA, you cannot convert future contributions to Roth without carrying over some of those gains, which leads to extra taxes and recordkeeping.
There are other important rules that must be kept in mind, like the fact that an individual can only have one traditional IRA and one Roth IRA open at a time. We recommend working with an expert when considering the Backdoor Roth IRA. Our advisors at BWM can help you assess if executing a Backdoor Roth IRA is right for your from a financial planning perspective, and can connect you with a CPA to help you carry out the strategy.
And Now the Main Event: The Mega Backdoor Roth 401(k) Strategy
The Mega Backdoor Roth 401(k) strategy looks and acts similar to a Backdoor Roth IRA, except it takes place inside a 401(k). One thing that sets 401(k)s apart from IRA’s is that they have much higher contribution limits than the aforementioned $6,000 or $7,000. Most people think the maximum amount that can be saved into their 401(k) is $19,500, plus an extra $6,500 catch-up contribution if you are 50 years or older.
However, that is only the amount an employee can elect to defer each year and receive certain tax benefits, either pre-tax or Roth. The total amount of money that can be stockpiled into a 401(k) in 2021 is $58,000, plus a $6,500 catch-up if you are 50+ years of age. This amount consists of three different pieces: employee elective deferrals, employer match, and employee after-tax non-Roth contributions.
- Employee Elective Deferrals – this is the money you elect to be taken out of your paycheck each pay period and saved into your 401(k), and is what people refer to when they say they save x% into their 401(k). Again, the maximum amount is either $19,500 or $26,000 depending on your age. All 401(k) plans accept pre-tax contributions, which receive the same tax benefits as traditional IRA contributions. Some 401(k) plans allow for Roth 401(k) contributions, which receive the same tax benefits as Roth IRAs, plus they do not have the income limits of Roth IRAs. It does not matter how much income you make; if your plan allows for Roth 401(k), you are always allowed to contribute. Commonly misunderstood, the income limits that affect Roth IRAs do not apply to Roth 401(k)s.
- Employer Match – this is what your employer promises to contribute into your 401(k) based on how much you put in yourself. Your employer match does not count towards your $19,500 or $26,000 elective deferral limit, but it does count towards your $58,000 total limit. Also, the employer match is always made with pre-tax dollars, even if you elect to save into Roth 401(k).
- Employee After-Tax Contributions – this is the money you elect to save into your 401(k) above and beyond the employee elective deferral limit. This savings does not receive the pre-tax or Roth benefits that the elective deferrals enjoy. The money is considered to be after-tax but non-Roth, meaning you pay taxes on the contribution and it grows tax-deferred, but you must pay income tax on any gains when you take out money in retirement. This is the portion of your 401(k) contributions that you will use for the Mega Backdoor Roth 401(k) strategy.
After-tax contributions are not very appetizing on their own; the only clear benefit is tax-deferral when the money sits in the account. Outside of that, you still face some form of a tax hit when you put the money in and when you take the money out, assuming the investments have grown. That is why the Mega Backdoor Roth 401(k) strategy works best if your 401(k) plan allows you to convert your after-tax, non-Roth dollars to a Roth inside the 401(k).
Just like the Backdoor Roth IRA strategy, once you convert the after-tax money to Roth, it grows and is later withdrawn tax free. If you do not do this immediate conversion, you will have to track the earnings on the after-tax money, roll that portion of the account to a traditional IRA, and pay taxes on any growth in retirement. Therefore it is paramount that the conversion occurs immediately inside the 401(k).
Even though the total permissible 401(k) contribution limit is $58,000 or $64,500, not all employers allow you to max out your 401(k). Companies can limit or restrict 401(k) contributions above and beyond the limit for employee elective deferrals, so you will want to check with your 401(k) plan administrator to understand your company’s policy. In San Diego, many companies like Qualcomm and Leidos allow for maximum after-tax contributions subject to an income-based formula. Some companies even allow you to automate the after-tax conversion to Roth.
BWM Financial advisors have experience working with the 401(k) plans of many local employers and can help you set up and optimize your savings strategy. Once your 401(k) is dialed-in, we can also help you think about the bigger picture when it comes to saving for retirement. For example, we can help you organize your savings and create a strategy tailored to you based on what is most important, utilizing vehicles like an HSA, Roth, ESPP, 401 k, trust, 529s, and more. We also help you think more about the long game. You need to consider how you will take money out in retirement when building a plan like this. Getting a large tax deduction each year while saving is a small part of the overall picture. We help people cut through the noise and clutter to weigh the different options and trade-offs that are best for them.