A mega backdoor Roth is a tax strategy you can use to dramatically increase contributions to a Roth individual retirement account and bypass the usual Roth IRA income limits. As with any Roth, your money grows without being taxed, and the funds can be withdrawn tax-free in retirement.
You may be able to make a mega backdoor Roth contribution if you:
-- Have a 401(k) plan at work.
-- Your 401(k) plan allows after-tax contributions.
-- Your 401(k) plan permits in-service withdrawals or rollovers.
What Is a Mega Backdoor Roth IRA?
There are several ways to fund a Roth IRA, and each strategy has different rules and restrictions. A mega backdoor Roth allows you to contribute significantly more funds to a Roth IRA than other Roth IRA funding strategies.
Roth IRA. A Roth IRA is an attractive retirement account because growth and distributions are tax-free, and you don't have to take required minimum distributions in retirement. Unlike a traditional IRA, the money contributed to a Roth IRA has already been taxed. However, a Roth IRA has income limits that prohibit high earners from contributing directly to an account and a small contribution limit of $6,000 to $7,000 per year, depending on your age.
Backdoor Roth. A backdoor Roth is a way for high-income individuals to bypass the ordinary income limits for a Roth. You can open a traditional IRA, and immediately convert it into a Roth IRA and pay the taxes. However, you can only contribute $6,000 a year to an IRA ($7,000 if you are over 50).
Mega backdoor Roth. Some people who have a 401(k) plan at work that allows after-tax contributions and in-service distributions have the option to create a mega backdoor Roth. If you meet all the rules and requirements, you can save an additional $38,500 a year in a Roth by putting after-tax funds in the 401(k) and then rolling it over to the Roth. "It's a fairly narrow group of people that get to do it, because of all the steps that are required, and many 401(k) plans are not set up to even allow it," says Adam Fuller, a financial advisor and principal at Homrich Berg Wealth Management in Atlanta.
[Read: How to Open a Roth IRA.]
How Does a Mega Backdoor Roth Work?
The most you can contribute to a 401(k) out of your paycheck on a pre-tax basis is $19,500, or $26,000 for individuals 50 and older. However, the overall IRS limit on contributions is $58,000 ($64,500 at age 50 or older). "Most people don't realize that they can actually contribute up to $64,500 to a 401(k)," says Mike Piershale, president of Piershale Financial Group in Barrington, Illinois.
After you have contributed the tax-deductible maximum of $19,500 (or $26,000 if 50 or older), you can contribute an additional $38,500 in after-tax contributions, if your 401(k) plan allows this type of contribution. You can then transfer that $38,500 to a Roth IRA, if your plan allows in-service distributions or rollovers.
However, if you receive an employer match, that counts against the maximum total contribution of $58,000 ($64,500 if 50 or older). For example, if you contribute $26,000 to a 401(k) plan and receive $14,000 from your company as a 401(k) match, that counts as $40,000 toward your $64,500 limit. Thus, you will only be allowed to contribute another $24,500 in after-tax money that can then be rolled over to the Roth IRA.
The Benefits of a Mega Backdoor Roth
If you make $38,500 in after-tax contributions to your 401(k) and it grows by $30,000 by the time you retire, you will not have to pay taxes on your original $38,500 because it was invested as after-tax money. However, you will be taxed on that $30,000 in investment growth because the money does not grow tax-free in a traditional 401(k) plan. However, if you were to roll that $38,500 over to a Roth IRA in the same year you make the after-tax 401(k) deposit, you won't owe income tax on the $30,000 of investment growth and can take tax-free withdrawals in retirement.
"This is a way to get a lot of extra money in that Roth and of course the Roth is the goose that lays the golden eggs, because for the rest of your life when you pull that money out, it all comes out tax free," Piershale says. "That's why they call them mega backdoor Roth, because you put this huge amount in."
How to Decide if a Mega Backdoor Roth Is Right for You
In order to use the mega backdoor Roth strategy, you need to make sure your company allows after-tax contributions to your 401(k), which many large companies do. Your company also needs to allow an in-service rollover while you're still working for that company. Additional limits may apply if you are highly compensated. "You have to be very careful to make sure you have everything you need. Otherwise, you may do the extra contributions and then realize that you can't roll it out," Fuller says. "Make sure you ask all the questions and know exactly that all the steps are in place to make it work smoothly."
Check with your human resources department or review your summary plan description to determine if your plan has the flexibility to allow the contributions and rollovers. Even if your plan doesn't, it's not necessarily the end of your options. "You can go to the employer and ask if they'll add it," Fuller says. "We've worked with some employers for some executives to try and get that done. A lot depends on the size of the company and other factors, but some companies will be amenable to making changes. It does create some additional costs for the company, so some may not be willing to do it."
If you are uncertain about your 401(k) plan's rules, it can help to work with a financial professional. "The key thing here is for an individual to work with their advisor to go through the steps to first make sure that it makes sense to do this, even to make additional contributions on an after-tax basis," Fuller says. "If they have a good financial foundation, and they're looking for extra ways now to save, this can work very well."