Backdoor Roth IRA vs. Mega Backdoor Roth 401(k)

Backdoor Roth IRA

If you’re involved in the investing world, you’ve probably heard of the Backdoor Roth IRA, but just in case you haven’t, here’s a quick refresher:

A Backdoor Roth IRA is a strategy for individuals to contribute to a Roth IRA account, even if their income exceeds the IRS limits for direct contributions to a Roth IRA.

The IRS sets income limits for individuals who want to contribute directly to a Roth IRA. The income limit for contributions changes annually, but you can reference the latest figures on Schwab . If you exceed this limit, then you cannot contribute directly to a Roth IRA. However, a Backdoor Roth IRA allows individuals to contribute to a Traditional IRA account and then convert that Traditional IRA to a Roth IRA.

This strategy is available to individuals of any income level—regardless of whether or not they are eligible for direct contributions to a Roth IRA.

How does a Backdoor Roth IRA work?

To execute a Backdoor Roth IRA, an individual first contributes to a Traditional IRA account. 

• TRADITIONAL IRA: A type of individual retirement account that allows individuals under an annual income limit to receive a tax deduction for contributing. If the contributor exceeds the income limit, contributions are still allowed, but as a post-tax contribution. A traditional IRA benefits from tax deferral until withdrawn during retirement (age 59 1/2 and older).
• ROTH IRA: Another type of IRA that allows individuals to contribute towards retirement is the Roth IRA. Unlike a traditional IRA, there is no upfront tax savings by contributing funds. Instead, the funds are contributed post-tax with the benefit of tax-free growth. Therefore, when you withdraw during retirement, there is zero tax liability to pay on the distribution.

Limitations & Important Considerations

It's important to note that there are contribution limits for Traditional IRA accounts, which change yearly. You can find the current contribution limits here .

Once you have contributed to a Traditional IRA account, you can convert it to a Roth IRA. This conversion can be done in the same year as the contribution, and there are no income limits or restrictions on the amount that can be converted from a Traditional IRA to a Roth IRA.

Two Nuances to Be Aware of

1. Any pre-tax contributions in the Traditional IRA will be subject to taxes when converted to a Roth IRA. It's important to consult with a tax professional before executing a Backdoor Roth IRA. This will help you avoid any unexpected tax liabilities. It’s advised that you do not have any pre-existing pre-tax IRA funds when executing this backdoor strategy.
2. You can “hide” your pre-existing pre-tax IRA funds inside of your employer’s 401(k) plan since 401(k) plans are governed by a separate set of rules and regulations. In doing so, you must transfer those pre-tax IRA funds into your 401(k) through a rollover process. Once completed, then you can consider the backdoor strategy. Again, it’s best to consult a tax professional before executing.

Overall, a Backdoor Roth IRA can be an effective way for you to contribute to a Roth IRA account even if you are not eligible for direct contributions due to income limits. It's essential to understand this strategy's potential tax implications and consult with a financial advisor or tax professional before executing it.

The Mega Backdoor Roth

The Mega Backdoor Roth is a powerful retirement savings strategy that allows high-income earners to contribute significantly more to their bucket of Roth funds than the backdoor Roth IRA mentioned above. This strategy is ideal for individuals who have maxed out their traditional 401(k) contribution limits and are looking for additional tax-advantaged retirement savings options.

This strategy involves making after-tax contributions to a 401(k) plan and converting those contributions to Roth funds. While this strategy has existed for several years, it's still relatively unknown to many individuals. Companies such as Meta, Amazon, Google, Apple, and Microsoft offer the Mega Backdoor Roth to their employees. To see the full list, check out levels.fyi - they have comprehensive compensation & benefits-related data for major employers.

Fun Fact!

The Mega Backdoor Roth strategy is relatively new and has gained popularity recently as more 401(k) plans have begun offering after-tax contributions and in-plan conversions to a Roth IRA.

While there is no exact date when this strategy was "introduced," it is believed to have emerged in the early 2010s due to changes to tax laws and regulations that made it easier for individuals to convert after-tax contributions to a Roth IRA.

Since then, more and more employers have added after-tax contributions to their 401(k) plans. The Mega Backdoor Roth strategy has become a popular way for individuals to save for retirement while taking advantage of the tax benefits of a Roth IRA.

Pros of the Mega Backdoor Roth

• Increased retirement savings: The Mega Backdoor Roth allows high-income earners to contribute additional after-tax dollars to their 401(k) plan, which can then be converted into Roth funds. This can significantly increase retirement savings, as the contributions and earnings will grow tax-free.

• Tax-free withdrawals: Roth IRA withdrawals are tax-free, meaning that individuals can save thousands of dollars in taxes during retirement.
• No income limits: Unlike a traditional Roth IRA, there are no income limits for the Mega Backdoor Roth. This means high-income earners can take advantage of this strategy, even if they are not eligible for a traditional Roth IRA.
• Diversification: Diversifying retirement savings across different tax buckets (traditional, Roth, and after-tax) can provide more flexibility during retirement, as individuals can choose which accounts to withdraw from based on their tax situation.

Cons of the Mega Backdoor Roth

• Complex process: The Mega Backdoor Roth can be a complex process, as it involves after-tax contributions, in-plan Roth conversions, and potentially working with a financial advisor to navigate the rules and regulations.
• Employer restrictions: Not all 401(k) plans allow after-tax contributions or in-plan Roth conversions. Individuals may need to check with their employer to determine eligibility for this strategy.
• Risk of losing tax benefits: If the after-tax contributions are not converted into a Roth IRA in a timely manner, individuals may miss out on the tax benefits of this strategy.

DID YOU KNOW?

If an employee were to take advantage of the Mega Backdoor Roth by contributing an additional $30,000 per year to their retirement plan, growing at an average of 8%, they would have added an additional $434,000 of tax-free retirement funds to their retirement savings after ten years and $1,372,000 after twenty years!

Pretty wild, huh?

Qualifications for the Mega Backdoor Roth

While the Mega Backdoor Roth does provide a little more flexibility than the Backdoor Roth IRA strategy, there are still some qualifications to be aware of before moving forward. To be eligible for the Mega Backdoor Roth, individuals must meet the following qualifications:

• Max out traditional 401(k) contributions: Before contributing to the after-tax portion of their 401(k), individuals must first max out their traditional 401(k) contributions for the year. For the latest 401(K) contribution limits, visit Fidelity , and for the latest IRA contribution limit, visit Schwab . Keep in mind that individuals over age 50 have a catchup provision that allows them to contribute additional funds beyond the annual limit.

• 401(k) plan allows after-tax contributions: Not all 401(k) plans allow for after-tax contributions, so individuals should check with their employer to see if they are eligible for this strategy.
• 401(k) plan allows in-plan Roth conversions: After-tax contributions can only be converted into a Roth IRA if the 401(k) plan allows for in-plan Roth conversions.
• Sufficient income: Since after-tax contributions are made with after-tax dollars, individuals must have sufficient income to contribute to this portion of their 401(k) plan.

DID YOU KNOW?

When performing the Backdoor Roth IRA, a pro-rata tax rule applies to IRA distributions that contain pre-tax and after-tax funds. 

Any distribution from an IRA account that includes pre-tax and after-tax funds must be prorated based on the account's percentage of pre-tax and after-tax funds. This means that if you have pre-tax IRA funds and want to do a backdoor Roth IRA conversion, you will be required to pay taxes on a portion of the conversion based on the percentage of pre-tax funds in your IRA account.

For example, if you have $100,000 in a traditional IRA, of which $80,000 is pre-tax, and $20,000 is after-tax. Let’s say you’re doing a backdoor Roth IRA conversion of $10,000; the pro-rata rule would require that 80% of the conversion (or $8,000) be taxed as ordinary income since 80% of your IRA account is pre-tax.

Final Thoughts

Both the Backdoor Roth IRA and the Mega Backdoor Roth through a 401(k) plan are strategies for individuals to contribute to a Roth IRA account, but there are some key differences between the two.

The Backdoor Roth IRA involves making nondeductible contributions to a Traditional IRA and then converting that Traditional IRA to a Roth IRA. This strategy is commonly used by individuals with high incomes that prevent them from directly contributing to a Roth IRA. 

Remember that a pro-rata tax rule applies for any pre-tax and post-tax funds conversion, so it is ideal for taking advantage of this strategy when you have a low-income year or no pre-tax IRA funds.

On the other hand, the Mega Backdoor Roth involves making after-tax contributions to a 401(k) plan and then converting those after-tax contributions to a Roth part of your 401(k) plan. This strategy is only available to individuals who have a 401(k) plan that allows for after-tax contributions and in-plan Roth conversions.

Another key difference between the two strategies is that the Backdoor Roth IRA can be done by anyone—regardless of whether or not they have a 401(k) plan. Alternatively, the Mega Backdoor Roth requires access to a 401(k) plan that allows after-tax contributions and in-plan Roth conversions.

Overall, both strategies can be effective ways to contribute to a Roth IRA. The Mega Backdoor Roth may appeal more to higher-income individuals as it allows for a higher contribution amount, while the Backdoor Roth IRA may appeal more to individuals who may not have a 401(k) plan that offers the features of a Mega Backdoor Roth.

Recommended Homework

1. Check to see if your employer offers the necessary 401(k) features to enable a Mega Backdoor Roth. 
2. If so, challenge yourself to find a way to contribute at least 5% to start and continue to increase your rate annually. All those tax-free gains for the remainder of your life can add up!
3. If you're interested in working with us to optimize your retirement strategy, click here to get started.

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