The mega backdoor Roth

In short

A friend of mine once told me he had maxed out his 401(k) and still felt like he was leaving money on the table. If you earn a good income and feel the same way, the mega backdoor Roth may be worth a close look. It lets some workers put after tax money into a 401(k) and then move it into a Roth account, where growth can come out tax free later. It only works if your employer's plan allows two specific features. So your first job is to ask your plan administrator, or read your summary plan description, and find out. Next, learn the total limit on all money going into your account in one year, which is the current figure, which the official source publishes each year. Then watch the timing, because moving the money quickly keeps taxes on the growth small. Last, keep a record of what you put in, since the tax form you receive later will depend on it.

The whole of it

What it is

I once watched a neighbor of mine fuss over a toolbox he had owned for thirty years. He knew every drawer but one, and that one held the best wrench. Many 401(k) plans have a drawer like that. You have probably heard of a regular Roth IRA, but high earners often cannot use one directly, because income limits shut the door. The mega backdoor Roth is a way around that wall, and it is legal when the plan permits it. You contribute after tax money to your 401(k), beyond your normal pre tax or Roth deferrals. Then you convert that money to Roth, either inside the plan or by rolling it out to a Roth IRA. That is the heart of it.

You should know the name is bigger than the idea. It is not a trick or a loophole nobody is supposed to see. The law lets a 401(k) take in both employee and employer money up to one combined ceiling. Some plans leave room under that ceiling for after tax contributions, and the mega backdoor simply uses that room. If you are the kind of person who likes to use what the rules already offer, you are in good company.

How it works

If you are holding a pay stub and wondering where this fits, think of three buckets. The first bucket is your own deferrals, the money you choose to set aside from pay, either pre tax or Roth. The second bucket is your employer's money, such as a match. The third bucket is after tax contributions, which are not the same as Roth deferrals. This third bucket is where the mega backdoor lives.

For the plan to work, two things must be true. First, the plan must let you make after tax contributions. Second, the plan must let you move that money to Roth, through what is called an in plan Roth conversion, or through an in service withdrawal, which means taking money out while you still work there. Without one of those two, the after tax money sits stuck, and it does not grow in the way you want.

Once the money is in, you convert it. Here is why speed matters. After tax contributions are not taxed when you move them, because you already paid tax on them. But any growth on that money before you convert is taxed as regular income. So if you convert soon after each contribution, the growth is tiny, and so is the tax. Some plans even do this automatically. If yours does, that is a real kindness.

The numbers, and where to find yours

A friend once said numbers make his eyes glaze over. I get that. So let us keep this plain and point you to the source. Three figures matter here. The first is the limit on your own deferrals for the year, which is the current figure, which the official source publishes each year. The second is the combined ceiling on everything going into your account, which is the current figure, which the official source publishes each year. The third is the extra catch up amount for people old enough to qualify, which is the current figure, which the official source publishes each year starting at age the current figure, which the official source publishes each year.

The room for after tax money is roughly the combined ceiling, minus your own deferrals, minus your employer's contributions. Your employer's match counts against that ceiling. So do any profit sharing deposits. That is why a big match shrinks the room you have left.

To find your own numbers, start with your plan's summary plan description, which your employer must give you. It tells you whether after tax contributions and Roth conversions are allowed. Your plan administrator can also tell you what you have contributed so far this year. For the official yearly limits, the Internal Revenue Service publishes them on its page for retirement plan contribution limits, and Internal Revenue Code section 415(c) is the law behind the combined ceiling. Check both before you act.

A worked example

I once knew a nurse practitioner named Dana who liked to plan on paper before she did anything. Let us walk through her year with plain figures, and you can check every step.

Dana earns a salary of 220,000 dollars. Her plan allows after tax contributions and in plan Roth conversions. Her employer matches 4 percent of her pay. That match is 220,000 times 0.04, which equals 8,800 dollars.

Dana decides to defer 20,000 dollars of her own pay. Her employer puts in the 8,800 dollar match. So money already counted toward the combined ceiling is 20,000 plus 8,800, which equals 28,800 dollars.

For this example, say the combined ceiling were 70,000 dollars. That is Dana's own made up figure, used only so the math is easy to follow. The real number is the current figure, which the official source publishes each year, and she would look it up. The room left for after tax contributions would be 70,000 minus 28,800, which equals 41,200 dollars.

Dana sets up an after tax contribution of 3,433 dollars a month. Over twelve months that is 3,433 times 12, which equals 41,196 dollars, just under her room. Each month she converts the new money to Roth right away. Because she converts fast, almost no growth builds up to be taxed. Say a small amount does, a total of 150 dollars over the year. If she pays tax at 24 percent, the tax is 150 times 0.24, which equals 36 dollars. Not bad for moving over forty thousand dollars toward Roth.

Where it goes wrong

I once watched a man build a fine fence and then find out he had built it on his neighbor's land. A little checking first would have saved him a lot of grief. The mega backdoor has a few spots like that.

The biggest one is that your plan may not allow it. Many plans do not offer after tax contributions, and many that do will not let you convert. If either piece is missing, the plan simply does not work for you. Do not guess. Ask.

Another trouble spot is the match. A big employer match uses up room under the combined ceiling, so your after tax space may be smaller than you hoped. Plan for that before you set your monthly amount.

Timing is a third snag. If you let after tax money sit for months before converting, the growth is taxed as ordinary income, and that tax can surprise you. Convert often.

Paperwork is the fourth. When you convert or roll out money, you get a tax form called a 1099 R. The after tax part and the growth part must be reported correctly, and tax software can stumble here. Keep your own record of each contribution. You may also want a tax professional for the first year.

A fifth snag is a test the plan itself must pass. The law requires 401(k) plans to treat lower paid and higher paid workers fairly through what are called nondiscrimination tests. If too few lower paid workers take part, the plan can fail, and high earners may get money sent back. Ask your administrator whether this has happened in past years. It can.

Questions to answer before you leave this page

Does your plan allow after tax contributions, and have you seen that in writing? Does it let you convert to Roth inside the plan, or take an in service withdrawal to a Roth IRA? What is your employer's match, and how much of the combined ceiling does it already use? How much room is left for you after your own deferrals and the match? Can your plan convert the money automatically, or will you have to remember each time? Who will help you read the 1099 R when it arrives, and where will you keep your contribution records? And have you looked at the Internal Revenue Service page for the current limits, so you are working from the real figures and not from memory?