The Mega Backdoor Roth Conversion is a strategy that allows high-income earners to contribute significantly more to tax-advantaged retirement accounts than traditional Roth IRA contribution limits allow. Let’s break down the key concepts and advantages of this approach.

Concept of Traditional or Regular Pre-tax 401(k)

  • Traditional 401(k): A retirement savings plan offered by employers where employees contribute pre-tax income. These plans are also called regular 401(k) plans. These contributions lower taxable income in the year they are made. However, withdrawals in retirement are taxed as ordinary income. Employers may also contribute through matching or profit-sharing.

Concept of Roth 401(k) Contribution

  • Roth 401(k): Similar to a Traditional 401(k) but contributions are made after-tax. This means there is no immediate tax break, but withdrawals in retirement are tax-free, provided the account has been open for at least five years and you are over age 59½. It allows you to lock in today’s tax rates for future tax-free withdrawals.

The sum of the regular pre-tax 401(k) and Roth 401(k) is subject to the IRS annual limit for employee elective salary deferrals which is up to $23,000 annual limit in 2024.

After-tax 401(k) Contribution

  • After-tax 401(k) contribution: The after-tax 401(k) contribution, not to be confused with the after-tax Roth 401(k), is an option offered by some 401(k) plans. Unlike employee deferrals, after-tax contributions aren’t limited by the standard employee contribution cap but instead fall under the total contribution limits. Any earnings on after-tax 401(k) contributions are taxed as income when you withdraw them, while the principal remains untaxed (unlike pre-tax 401(k) contributions). In contrast, both the principal and earnings in a Roth 401(k) are tax-free when withdrawn.

Mega Backdoor Roth Details

The Mega Backdoor Roth Contribution is a strategy that allows individuals to contribute significantly more to tax-advantaged retirement accounts than the standard limits. Here’s how it works and the key details you need to know:

Annual Total Contribution Limits of All Tax-Deferred and Tax-free Contributions

  • For 2024, the total contribution limit to a 401(k) plan is $69,000 (or $76,500 for those over age 50). This total includes:
    • IRS annual limit for employee elective salary deferrals that include both pre-tax contributions to regular or traditional 401(k) plans and Roth 401(k) if available (up to $23,000 or $30,500 if over 50).
    • All employer contributions or matches.
    • All other after-tax contributions to 401(k)s.

Note, the above includes all of your contributions, regardless of how many separate accounts you have.

Process for Mega Backdoor Roth

  1. Max out your pre-tax 401(k) and Roth 401(k) contributions: First, contribute the maximum allowed ($23,000 or $30,500 if over 50) to your 401(k) using pre-tax contributions.
  2. Make after-tax contributions to 401(k) (again, not to be confused with Roth 401(k)): Once you’ve maxed out your regular 401(k) contributions, you can make after-tax contributions up to the overall $69,000 (or $76,500 if over 50) limit, including any employer contributions. After the after-tax contribution to the regular 401(k), you can roll them over into a Roth account, assuming a so-called in-service or in-plan distribution. The following are the details:
    • In-Plan Roth Rollovers: This allows employees to roll over their after-tax 401(k) contributions into a Roth 401(k) within the same employer plan. This means they can convert after-tax contributions to Roth without leaving the plan, allowing future earnings on those contributions to grow tax-free.
    • In-Service Withdrawals to Roth IRA: If allowed by the plan, employees can take an in-service withdrawal of their after-tax 401(k) contributions and roll them over into a Roth IRA outside the plan. This also allows tax-free growth on earnings and can offer more investment choices and flexibility.
  3. Some plans offer one or both of these options, so it’s essential to check with the plan administrator.

Key Considerations

  • Employer Plan Requirements: Not all employers offer after-tax contributions, in-plan Roth conversions, or in-service withdrawals. The Mega Backdoor Roth 401(k) is only available in plans that allow these features.
  • Maximizing Contributions: If your plan allows it, this strategy can significantly increase the amount you save in tax-advantaged accounts. The total contribution limit far exceeds the standard Roth IRA contribution limit ($6,500 or $7,500 for those over 50), making this a powerful way to build wealth.

Benefits of Mega Backdoor Roth 401(k)

  • Tax-free growth: Once converted to a Roth account, contributions and their growth are tax-free, provided you meet the required conditions (over age 59½ and the account has been open for 5+ years).
  • Higher savings potential: The strategy allows you to contribute well beyond the regular Roth IRA and 401(k) contribution limits, offering high-income earners more opportunity to save and invest in a tax-advantaged manner.

Mega Backdoor Roth IRA Conversion Details

On the other hand, the Mega Backdoor Roth IRA conversion has also been mentioned in the media. The difference between a Mega Backdoor Roth IRA conversion and a Mega Backdoor Roth contribution is that in a Mega Backdoor Roth contribution, you need to contribute after-tax earnings to your regular 401(k) account (which requires your employer to separate after-tax from pre-tax savings). You then convert those contributions to a Roth 401(k) or a Roth IRA, assuming your plan allows in-plan rollover or in-service withdrawals.

The Mega Backdoor Roth IRA conversion, on the other hand, simply involves converting your traditional IRA to a Roth IRA. There is no annual limit on the amount you can convert, but the converted amount will be subject to income tax. Additionally, you need to be aware of the so-called pro-rata rule for Roth IRA conversions.

Summary

  • About 20% to 25% of 401(k) plans now offer Roth 401(k) options, making this strategy accessible to more individuals. In fact, most technology companies offer Roth 401(k) plans, recognizing the power of tax-free growth. However, you need to check with your employers to see whether they allow after-tax 401(k) contributions and in-plan rollover to a Roth 401(k) or in-service withdrawals to a Roth IRA.
  • The Mega Backdoor Roth Savings is a powerful tool for high-income earners who want to maximize their retirement savings and enjoy tax-free withdrawals. By leveraging this strategy, you can compound your savings dramatically over time, providing significant long-term financial benefits.