You’ve maxed out your 401(k), now what? As clients prepare for retirement, they often look for smart ways to save additional money. There are plenty of options for those dollars after you hit your limits. But, the question remains: are there any that allow for tax-favored savings? The answer lies in one of the more sophisticated strategies out there, which I refer to as the Mega Backdoor Roth. So how does the Mega Backdoor Roth work? Why might it be appropriate for you?
The Mega Back Door Roth:
The first requirement to be eligible is working for a company that allows after-tax contributions to their 401(k). Most of the large companies we see regularly (DowDuPont, Chemours, Axalta) offer this feature. (It should be noted that after-tax 401(k) contributions are different than Roth 401(k) contributions.) It is important to know what your employer match contribution will be for the year. Let’s say you make $250,000/yr and your company matches 6%. That means your company will contribute $15,000 in addition to your contributions.
Again, assuming a typical 50+-year-old employee is maxing out their contribution, that means a contribution of $18,000 (+$6,000 of catch-up), in addition to the $15,000 of employer contribution. It then, in total, becomes a pre-tax contribution of $39,000. In 2017, the IRS limited contributions to a qualified retirement plan to $54,000 + $6,000 catch-up (if age 50 or older). That limit is exactly what the Mega Backdoor strategy is all about. Sticking with my example, there is $60,000 of eligible contributions to age 50+ (or older) employee’s qualified plan. They have satisfied $39,000 of that contribution through their personal and employer contributions. However, this leaves $21,000 of eligible contributions.
Since your employer is not contributing anymore, and the IRS won’t allow employees to contribute more than the $24,000 pre-tax, it leaves just one place eligible to contribute. This one place is the after-tax 401(k) provision I mentioned earlier. Let’s assume you’ve contributed your allotted $21,000 of after-tax dollars to your 401(k); now what? Hope you are sitting down as now comes the beautiful part. You can call up your 401(k) provider and ask them to send your after-tax 401(k) funds home. On the call, some providers will even let you code as a Roth conversion. Once these funds come home, you contribute/convert them immediately to a Roth IRA of your choosing. Voila! You’ve now contributed that unutilized $21,000 to a Roth IRA for the year 2017.
Why this strategy is so powerful:
For starters, a married couple earning $186,000-$196,000 in 2017 is phased out of contributing to a Roth IRA in the first place. With the Mega Backdoor strategy, the person in the above scenario has now successfully contributed $21,000 to a Roth IRA although technically ineligible. If you’ve read my past blog (Roth Conversion Blog), you already know the power and my affinity to the Roth IRA. You have the ability for tax-free growth on these funds, which otherwise would sit in a non-retirement account. There they’d be exposed to capital gains tax, which can be avoided. Additionally, you can take contributions penalty-free from a Roth IRA, so even your downside risk is mitigated.
When taking out funds, any growth on the after-tax 401(k) contributions will be treated as ordinary income. That said, you can simply roll over those growth earnings to a Traditional IRA and avoid paying any tax on them for the time being. Unfortunately, you can’t discriminate which funds to roll out of your 401(k). Let’s assume you are eligible to roll out your entire balance because you are over the 59.5 typical restrictions. To do this strategy, you’d have to move the entire 401(k) to an IRA and the after-tax portion to a Roth IRA.
There’s no harm in doing this. Just know to employ the Mega Backdoor Roth strategy, you’d have to find a place for your 401(k) balance. This is usually an existing, or new, Traditional IRA. My recommendation is to annually contribute. Then convert at the end of the year so you can give yourself the maximum amount of time to defer dollars in the Roth IRA. This gives you as many tax benefits as possible!
There it is in a nutshell: Or is THIS it in a nutshell? 🙂 In any event, I hope this strategy proves beneficial for you as you prepare for retirement. I know it may be a bit confusing, but don’t worry. Feel free to reach out if you have questions, or talk to a financial planner who is well versed in this strategy if you need help. I may just have one to recommend!