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Did you know there’s a way to get up to $56,000 into your Roth IRA every year even though the contribution limit is $6,000 per year?
Dubbed the “Mega Backdoor Roth,” this strategy allows taxpayers to increase their annual contributions into their Roth IRAs by as much as $56,000 (for 2019).
A Quick Background on Retirement Account Types
Retirement accounts such as IRAs and 401(k)s are vehicles to save funds for your later years. It’s important to understand these concepts in order to fully understand the Mega Backdoor Roth! Before jumping in, you might want to read our "refresher" so that you're up to speed with the basics.
Read Here: 3 Minute IRA and 401(k) Refresher Read
An Extra $56,000 In Your 401(k) - How?!
If you are contributing to an employer-sponsored retirement plan such as a 401(k), you may be able to make extra voluntary “after-tax” contribution beyond the $19,000 limit per year (for 2019). These after-tax contributions are not to be confused with Roth 401(k) contributions. However, not all 401(k)s allow these contributions, in fact, only about 48% of all 401(k)s allow it and only about 6% of people take advantage of it.
After Tax 401(k) Contribution Definition:
Employees can contribute $19,000 of earnings to an employer 401(k) plan but technically, the maximum anyone and their employer can contribute to ALL retirement plans is $56,000 (for 2019). So, if your employer allows it, you can contribute more than the $19,000, which comes out to an additional after-tax $37,000 (for 2019) or cumulative $56,000 (if you prefer to contribute everything to an after-tax 401(k).
If allowed by your employer, you can make after-tax contributions after you max out the initial employee contribution limit. This means that on top of the $19,000 limit, you may be able to make so-called after-tax 401(k) contributions of up to $37,000 ($56,000 less $19,000) for 2019. You can also opt to contribute $56,000 directly to an after-tax 401(k) bypassing the $19,000 traditional or Roth 401(k) contribution.
These after-tax 401(k) contributions are not deductible like traditional 401(k) and earnings on these accounts are taxable, unlike Roth IRAs. However, these contributions are essential for the Mega Backdoor Roth strategy which involves a rollover from after-tax 401(k) contributions to a Roth IRA, enabling you to secure tax-free growth on those assets.
What’s the difference between After-Tax Contributions and Roth Contributions to my 401(k)?
After-tax contributions have no tax benefit on the way in or out. They are subject to tax when you contribute them and subject to tax on any growth. Roth contributions are subject to tax when you contribute them but they are not subject to tax on any growth.
What is a Mega Backdoor Roth?
Mega Backdoor Roth is a strategy allowing taxpayers to get as much as $37,000 (for 2019) extra into their Roth IRA by rolling over after-tax contributions from a 401(k) plan. That number increases to $56,000 if you opt to contribute everything directly to an after-tax 401(k). But you can only take advantage of the Mega Backdoor Roth if your 401(k) plan meets certain criteria. Your plan must meet all of the criteria (below) to take full advantage of this unique retirement savings opportunity.
Can I do a Mega Backdoor Roth? Does my 401(k) plan meet the criteria?
To take advantage of Mega Backdoor Roth, your employer’s 401(k) should meet these criteria.
1. Must Allow After-Tax Contributions. Your plan must allow extra voluntary after-tax (not to be confused with Roth) contributions over the $19,000 contribution limit. The ideal scenario is if you can contribute up to the full $56,000 ($19,000 + $37,000) limit or contribute $56,000 directly to an after-tax 401(k), bypassing the $19,000 in traditional or Roth 401(k) contributions.
2. Should Allow In-Service Distributions/Conversions. Your 401(k) should allow so-called “in-plan” Roth conversions or “in-service” non-hardship distributions, which are a form of rollover. An “in-plan” conversion allows you to roll over to a Roth IRA within your employer’s retirement plan. Meanwhile, “in service” distribution or non-hardship withdrawal refers to converting contributions from your 401(k) to an IRA while you are still with your employer. If your employer does not allow in-service withdrawals, you can still execute on this strategy but will have to do the rollover when you leave your employer, which can result in a higher tax bill because you may have more growth.
If you have a self-employed 401(k) (also known as solo 401(k)), it’s also possible to implement a Mega Backdoor Roth. But you have to make sure that the plan allows after-tax contributions and provides access to in-service withdrawals.
What’s a Rollover?
A rollover refers to the transfer of funds from a retirement account such as a 401(k) to an IRA. You may also roll over funds from one IRA account to another.
Depending on your plan, you may be able to do a direct rollover. A direct rollover allows you to move your contributions to your designated IRA account without getting involved. Here, your plan administrator directly sends a check to an IRA or another plan. This usually happens when you are maintaining all your accounts with one company.
In some cases, you may have to be involved in the process. For instance, if you want to rollover an IRA from Fidelity to Vanguard, Fidelity will issue a check for the contributions you want to withdraw in favor of Vanguard. Once you receive the check, you have to send it to Vanguard and have it deposited within 60 days to ensure it’s not considered as a distribution.
How can I figure out if my 401(k) plan qualifies for the Mega Backdoor Roth?
Send an email to human resources asking the following.
Can we make after-tax contributions to our 401(k) plan?
Can we contribute up to the $56,000 maximum limit from all sources?
Are we allowed to make an in-plan rollover to a Roth IRA? How about an in-service non-hardship distribution?
How often are we allowed to perform a rollover or an in-service distribution?
Here is a sample email that you can send to HR or your 401(k) plan administrator:
I would like to confirm that the 401(k) plan here at <company> allows me to implement a savings strategy known as a "Mega Backdoor Roth". The strategy is characterized by the ability to make after-tax contributions to my 401(k) and then to do in-service withdrawals for after-tax contributions to a non-company Roth IRA.
Please point me to the plan documents that explain how to do this.
My understanding is that I can make (in 2019) a $19,000 pre-tax or Roth contributions to my 401(k) and receive <applicable percentage> as a company match. In addition, the IRS permits the employer and employee to contribute up to a total of $56,000, which is broken down into the $19,000 traditional or Roth employee contribution, the employer match, and the remainder, which can be as high as $37,000 in after-tax contributions in the absence of an employer match. In addition, I believe I can contribute the entire $56,000 after-tax if I want to, bypassing the $19,000 traditional or Roth contribution.
I can then make an in-service withdrawal of only the after-tax contributions (plus earnings) to a non-company Roth IRA. No pro-rata rule applies to this type of rollover.
Can you tell me if <company>'s plan restricts the amount of after-tax contribution I can make? Also, how often can I do an in-service withdrawal to my Roth IRA?
What are the benefits of Mega Backdoor Roth?
If you are maxing out your 401(k) and have maxed out your traditional or Roth IRA contributions outside of work on your own, the Mega Backdoor Roth IRA may be an effective strategy for you to get more money into your Roth IRA which allows tax free growth over your lifetime.
By using Mega Backdoor Roth in 2019, you can potentially get an additional $37,000 ($56,000 less $19,000) into your Roth IRA. Or you can opt to contribute $56,000 directly to an after-tax 401(k) and roll it to a Roth IRA, bypassing the $19,000 traditional or Roth 401(k) contribution.
Upon reaching 59 ½, you can take distributions tax-free from your Roth IRA and the earnings on your account will not be subject to taxes either.
The Mega Backdoor Roth IRA is especially beneficial if you anticipate your earnings will be higher when you are in retirement. Roth IRA distributions are excluded from your taxable income and you won’t pay taxes upon withdrawal. If you are in a higher tax bracket when you retire than you are when you are working, this will benefit you by making your overall tax bill on those funds less overall.
Another benefit of Roth IRAs is that unlike traditional IRAs or 401(k)s, you don’t need to take required minimum distributions (RMD) at any point. However, if the owner of the Roth IRA dies and someone other than the spouse inherits, the required minimum distributions will apply. RMDs start either on the end of the year containing the fifth anniversary of the owner’s death for a lump sum distribution or on the Dec. 31 on the year following the owner’s death for Roth IRA rolled over to an inherited Roth IRA.
Step by Step Mega Backdoor Roth Instructions
If your 401(k) plan allows after-tax contributions above the $19,000 limit and permits Roth rollovers or in-service withdrawals, it’s possible to do a Mega Backdoor Roth. Here are the basic steps on how to employ this strategy.
1. Contribute the maximum amount to your employer 401(k) and Roth IRA (or Traditional IRA if you don’t qualify, or use a Backdoor Roth IRA). In 2019, the maximum contribution is $19,000 to a 401(k) and $6,000 to an IRA (Roth or Traditional). Alternatively, you can opt to contribute $56,000 directly to an after-tax 401(k) and roll it to a Roth IRA, bypassing the $19,000 traditional or Roth 401(k) contribution.
2. If your employer allows it, make an after-tax contribution to your 401(k) of up to $37,000 ($56,000 less $19,000 less any employer match contributions). After-tax contributions are different from contributions to your traditional or Roth 401(k) which are still limited to the $19,000 per year (for 2019). Employer contributions reduce the $37,000 limit dollar for dollar. Again - you can alternatively opt to contribute $56,000 directly to an after-tax 401(k) and roll it to a Roth IRA, bypassing the $19,000 traditional or Roth 401(k) contribution.
3. Roll over after-tax 401(k) contributions to a Roth IRA as soon as possible. If you received funds from your 401(k) as distribution into your own personal account instead of directly to a Roth IRA administrator, you need to reinvest those funds to a Roth IRA within 60 days from the distribution date or face penalties. You should also receive a Form 1099-R for the 401(k) rollover. After-tax contributions rolled over to a Roth IRA are not subject to tax. But earnings on the contributions are taxable and should be reported on your tax form Form 1040 and taxed as ordinary income
Are There Any Tax Consequences Of a Mega Backdoor Roth?
If your after-tax contributions have grown before you do the in-service rollover, you will be subject to tax when you roll over those funds. If you are doing the transfers frequently, then your tax bill should not be significant. Some companies allow you to roll over as frequently as every pay period. If your employer does not allow in-service withdrawals, you can still do the Mega Backdoor Roth but you will have to do it when you leave the employer, in which case you are likely to have some taxable earnings and possibly a larger tax bill.
Caution: Many Financial Advisors Don’t Fully Appreciate or Understand the Mega Backdoor Roth
In asking your CPA, Financial Advisor, HR Department, or Tax Advisor about the Mega Backdoor Roth, they may mention something called the pro-rata rule, and may warn you about doing a partial rollover of the funds in your after-tax 401K. They may explain that this may cause tax consequences. However, what they may not know is that you are allowed to peel off your Non-Roth After-Tax Contributions and roll them to a Roth IRA without rolling over your Pre-Tax or Roth Contributions. No pro-rata rules apply to this type of in-service distribution. This is great news for people using the Mega Backdoor Roth!
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Supersize Retirement Savings While Minimizing Taxes
A Roth IRA is a powerful tool to manage your retirement savings. Aside from allowing you to make tax-free withdrawals and shielding the fund’s earnings from taxes, there are also no minimum distributions for Roth IRAs.
The key to an effective retirement strategy is to plan ahead. Remember Roth IRAs are just one part of the puzzle. Other small strategies can also help you retire comfortably.
To discuss all aspects of your retirement, work with professionals. Crafting a plan which minimizes taxes and maximizes your income can help you make better investment decisions for your retirement.