A little-known strategy allows high earners to use after-tax contributions to a 401(k) to fund a Roth IRA. It’s called a mega backdoor Roth because the dollar amounts involved are typically large. Here's how it works:
Example: A 50-Year-Old Employee Contributes the Maximum to a 401(k) for 2021
Employee contributes the maximum regular (also known as pre-tax) contribution plus an over 50 catch-up: $26,000
Employer provides a matching contribution: $13,000
Total Annual Contribution to 401(k): $39,000
However, the maximum contribution limit to a 401(k) for 2021 for employees over 50 is $64,500. How can this individual reach the $64,500 limit? The employee can make after-tax contributions to contribute an additional $25,500 ($64,500 limit – $26,000 employee contribution – $13,000 employer contribution = $25,500).
Why would someone want to do this?
High-income individuals who otherwise are not eligible for a Roth IRA can rollover the after-tax contributions they make in a 401(k) into a Roth IRA.
How does it work?
Call your 401(k) provider and ask if your plan offers after-tax contributions. If it does, ask if the plan permits you to rollover your after-tax contributions into a Roth IRA (i.e., in-service withdrawals or in-plan conversions). According to a survey by the Profit Sharing Council of America, more than 70% of 401(k) plans allow in-service withdrawals, so it’s likely your plan offers this feature (Source: Plan Sponsor Council of America, 59th Annual Survey, 2016). (Note: If your plan allows for after-tax contributions but not in-service withdraws, this strategy can still work, contact me for more information).
You would then increase your 401(k) contributions so that when your pre-tax contributions are exhausted, all additional contributions would fund your after-tax sources until you hit the maximum allowable limit. Once you have a sufficient amount in after-tax sources, you could roll the after-tax dollars into a Roth IRA.
The Mega Back Door Roth is a unique way for high earners to get access to a Roth indirectly.
If you have been making after-tax contributions for years and haven’t made any in-service withdrawals, you may have a sizable amount in your after-tax sources. If you choose to roll all or part of this money over to a Roth IRA, the IRS requires your withdrawal to be a combination of your after-tax contributions and the earnings on those contributions.
Your 401(k) provider will likely mail you two separate checks—one for the after-tax contributions and a second one for the after-tax earnings on those contributions. After-tax contributions can be rolled over to a Roth IRA tax-free as long as the check is made payable directly to the firm where you’re rolling over the assets to. After-tax earnings can be rolled over to a Traditional IRA tax-free. If you want to move your after-tax earnings into a Roth IRA, that would be a taxable event.
The calendar year after your IRA rollover takes place, your 401(k) provider will report the rollover on Form 1099R in January, and the firm that receives the IRA rollover will report it on Form 5498 by May 31. These tax forms are generated for reporting purposes only.
If you are a high earner and your plan allows for after-tax contributions, the Mega Back Door Roth is a unique way to get access to a Roth indirectly. There is much more to this strategy than I have room to post here, I suggest you speak to a qualified tax or financial professional to ensure you employ this strategy correctly.
How is your financial planning going? If you are a high earner and haven't heard of the Mega Back Door Roth, it's time for us to speak. For a complimentary consultation to review the Mega Back Door Roth plus other tax-advantaged strategies for high earners, contact me:
Michael Aloi, CFP®