Mega Backdoor Roth Contributions: Sounds like a Special Super-Power — Is It?

In order to explain the value of the mega backdoor Roth, it is important to understand the basics of the Roth account. Roth accounts offer a way to contribute after-tax money into a retirement account and any growth can accumulate tax free. Any qualified withdrawals are tax free as well. Roth accounts can take the form of an IRA or a 401(k). The main differences between the two are that employers offer 401(k) plans, but individuals open IRA accounts independent from their employers, and there is an income limit to contribute to a Roth IRA, but no income limit is required to contribute to a Roth 401(k).

Increasing numbers of employers are offering their employees a 401(k) plan that allows for Roth contributions in addition to the traditional 401(k) contributions. Since the traditional 401(k) offers a tax deferral and the Roth 401(k) doesn’t (with the tradeoff of tax-free growth on earnings), it is important to understand that one plan may be more appropriate than the other depending on the circumstances. You should consider many factors in determining which “bucket” to contribute to, including your current tax bracket, expectations about future tax rates, and the tax composition of your existing portfolio. The use of a Roth 401(k) is appealing to many people, especially those who cannot contribute directly to a Roth IRA account because of income limitations, as mentioned above.

In addition to the possibility of participating in a retirement plan that offers a Roth option, another way may also be available to pack more into the Roth using the 401(k)! The maximum amount an employee can contribute to a 401(k) (either tax-deferred or Roth, if available) is $23,000 for 2024 ($30,500 if the contributor is at least age 50 at any point during the calendar year). For some people, this is a significant amount of income that can be socked away for retirement. However, we can even go a step further in certain cases (again, depending on the plan). This relatively recent offering available in some 401(k) plans is the ability to take advantage of a “mega” Roth strategy. In this case, the 401(k) plan would allow employees to contribute after-tax dollars to the plan and then immediately convert to Roth, either to the Roth 401(k) “bucket” or to a Roth IRA. Keep in mind that because of the many moving pieces, it’s crucial to understand your specific employer 401(k) plan and allowable options.

The 401(k) plan has to allow for “after-tax contributions,” which is different than the Roth option. The after-tax contributions are just that — after-tax; however, unlike the Roth, the earnings are tax deferred, not tax free. This after-tax bucket, however, can be a funnel to the Roth. How? Well, the 2024 combined maximum total amount an employee and employer can contribute to the 401(k) is $69,000, or $76,500 if the contributor is at least age 50 at any point during the calendar year. So, if you subtract your traditional and Roth 401(k) contributions along with the employer’s match from the maximum, you know what can be contributed to the after-tax part of the 401(k).

The next step is extremely important in order to maximize this strategy. The plan has to allow for in-service withdrawals to a Roth IRA or in-plan rollovers to the Roth 401(k), since the goal is to get all of these dollars immediately to the Roth before any earnings start to accrue; otherwise, earnings left outside of the Roth will be taxed. The good news, though, is that if earnings do accumulate before the dollars can get moved out, the IRS allows rollover funds to be split, so the after-tax contributions go to a Roth IRA and earnings go to a traditional IRA. The earnings remain tax deferred and taxes eventually have to be paid, but the after-tax contributions that go to Roth can grow tax free.

Here is an example: Joe, a 45-year-old employee of ABC Corp., participates in the company’s 401(k) plan and contributes $12,000 to the traditional pre-tax portion of the 401(k) and $11,000 to the Roth. Joe has maxed out his combined tax-deferred and Roth 401(k) contributions. However, ABC allows for after-tax contributions as well. In addition, ABC matches up to 3% of Joe’s compensation to the 401(k). If Joe makes $250,000/year, ABC matches $7,500. The total contributions equal $30,500. Joe would like to save more and is informed that he can make up to $38,500 of after-tax contributions (maximum $69,000). Additionally, his plan allows him to immediately convert the after-tax contributions to the Roth IRA he previously set up. If he proceeds and converts his after-tax contributions immediately, Joe will be able to add a total of $49,500 to Roth via his 401(k) in 2024!

Not all employer 401(k) plans allow for after-tax contributions and the ability to complete in-service withdrawals/rollovers, but more are starting to pop up. The mega back door Roth is definitely worth looking at if your employer allows it.

Regardless of the type of retirement plan your employer offers, Bluerock can assist you in evaluating your options.

As always, we are here to help if you have any questions.