Mega backdoor Roth

In short

A friend of mine once asked why her coworker could stash far more in a Roth than she could, and the answer was a quirk in some workplace plans. If your plan allows after tax contributions, you may be able to move them into Roth money. That move is what people call the mega backdoor Roth. It works only if the plan lets you do each piece. A good first step is asking the plan administrator three plain questions about after tax contributions, in plan conversions, and withdrawals while still employed. Then find the total limit for all contributions in a year, which is the current figure, which the official source publishes each year. Guessing about any of it is risky, because one missing feature can break the whole path.

The whole of it

What it is

I once watched a neighbor try to fit a big couch through a small door, and it taught me something about limits. Retirement accounts have a front door that is narrow, and then a side door that is wider. The mega backdoor Roth is that side door.

Here is the idea in plain words. A 401(k) plan has a limit on what you can put in from your own paycheck, called the employee deferral limit. This year that figure is the current figure, which the official source publishes each year. But the law sets a second, higher limit on the total that can go in from all sources, which is the current figure, which the official source publishes each year. That total counts your deferrals, any employer match, and any other employer money.

The space between those two numbers is the room. Some plans let you fill it with after tax contributions. After tax means you already paid income tax on that money, so it does not lower your tax bill today. Then the plan lets you turn that money into Roth money. That last step is the mega backdoor Roth.

How it works

If you are holding a plan document and wondering where to begin, start with three features. The plan must allow after tax contributions, and not every plan does. The plan must also let you convert that money to Roth, either inside the plan or by moving it to a Roth IRA. And the plan must also allow that conversion during employment, since some plans permit it only after a worker leaves. Miss any one, and the path closes.

Think of it as a short walk with three gates. At the first gate, you send after tax money from each paycheck into the plan. At the second gate, the plan changes that money into Roth money. At the third gate, the money sits and grows. The in plan version keeps the funds in the 401(k) as a Roth balance. The other version sends them to a Roth IRA.

Timing matters here. The after tax money itself was already taxed, so moving it creates no new tax on that part. But any growth earned before the move is a different story. That growth is not yet taxed, so it counts as income when converted. This is why many people convert often, so the growth stays tiny.

The plan also has to pass testing rules. Employers run yearly checks to make sure the plan does not favor higher paid workers too much. After tax contributions are part of those checks. A plan can fail, and when it does, the employer may have to send money back. Some employees find their contributions get capped for that reason. The plan administrator can tell you if that applies.

The numbers, and where to find yours

I have found that a good deal of confusion comes from mixing up three different limits, so let us pull them apart. The first is the employee deferral limit, which is the current figure, which the official source publishes each year. The second is the total limit on all contributions, which is the current figure, which the official source publishes each year. The third is a catch up amount for people at or above age the current figure, which the official source publishes each year, and it is the current figure, which the official source publishes each year. Federal law, in Internal Revenue Code section 414(v), places the catch up amount outside the total limit. The plan itself must choose to permit catch up contributions, and the plan document says whether it does.

To find room for after tax money, take the total limit and subtract what goes in from other sources. That means your own deferrals plus the employer match plus any other employer money. What is left is the most you could add as after tax contributions.

Where do you find your own figures? Your pay stub shows what you put in. Your plan statement shows the match. The summary plan description is a document every plan must give you, and it spells out which features your plan allows. The Internal Revenue Service publishes the yearly limits on its website, and the Department of Labor explains how plan documents work. Your plan administrator can answer the rest.

A worked example

Let me tell you about a woman named Dana. She earns a salary of $120,000 and works for a company with a plan that allows every feature. She puts in $20,000 from her own pay. Her employer matches 4 percent of salary, and 4 percent of $120,000 is $4,800.

Say the total limit were $70,000 for the sake of the story. That is a plain figure for this story and not the real limit. Add Dana's own money and the match. $20,000 plus $4,800 is $24,800. Subtract $24,800 from $70,000, and the room left is $45,200.

If Dana wants to use all of it, she would send $45,200 as after tax money over the year. Spread across 26 paychecks, $45,200 divided by 26 comes to about $1,738 a paycheck. She sets that amount, and each time the plan changes it to Roth money soon after it lands. Because she converts fast, the growth is tiny, and the tax on it is tiny too.

Say a paycheck's after tax money grew by $15 before it was converted. That $15 is taxed as income. The other $1,723 was already taxed, so it moves with no new tax. That is $1,738 less $15. Small bills like that are the cost of the method. Dana can live with them.

At year end, Dana holds a bigger Roth balance than her coworkers who stuck to the front door. She did not get a bigger tax break today. She got more tax free growth later, which is a different thing entirely.

Where it goes wrong

I do not say this to scare anyone. Plenty of careful people stumble here, and it is no mark against them. The first slip is assuming the plan allows it. Many do not. The summary plan description shows which features a plan allows, so it is the first thing to read before any paycheck changes.

A friend of mine once let a balance sit for months, and that points to another slip, which is waiting too long to convert. When after tax money sits for months, it grows, and that growth is taxed when it moves. A quick conversion keeps that bill small. Slow conversion makes it bigger.

A third trouble is the testing rule I mentioned. If the plan fails its check, the employer may refund some contributions. That can leave you with a taxable payout and a surprise. Ask the administrator whether the plan has had trouble with testing before.

A fourth is mixing up the two paths. In plan conversion and a Roth IRA rollover are not the same. If money moves to a Roth IRA, rules about pre tax and after tax money can apply, and the paperwork has to be right. The IRS publishes guidance on how rollovers are treated. A tax professional who knows the person's situation can explain how those rules apply.

Last, people forget the cash side. Money sent as after tax contributions is money the saver cannot spend this year. Covering the bills comes first. It is a fine thing to save hard, but nobody wants to borrow to do it.

Questions to answer before you leave this page

Does your plan allow after tax contributions, and have you read the summary plan description to be sure? Does it let you convert that money to Roth inside the plan, or move it to a Roth IRA, and can that happen while you still work there? What is the total limit for all contributions this year, and how much of it is already used by your own deferrals and the employer match? How much room does that leave for after tax money, and what would that be per paycheck? How often can you convert, and will you do it fast enough to keep the taxable growth small? Has the plan ever failed its yearly testing, and what happens to your contributions if it does? Are your bills covered if you send that much to savings? And who will you ask, the plan administrator or a tax professional, if something in the paperwork seems unclear?