There’s a little known (and rarely used) provision in some 401(k) plans that catches the attention of lawyers from time to time.
If available, it could allow you to make an additional $36,000 in Roth IRA contributions each year (aka the Mega Backdoor Roth IRA coined by Jim Dahle).
Unfortunately, for most of you, this won’t be an option. But, I think you should explore and report back to me if your firm plan will let you do it.
Before we dive into figuring out whether your plan allows Mega Backdoor Roth IRA contributions, let’s make sure everyone has the background facts.
When contributing to a 401(k), there are three different types of contributions you can make: (1) pre-tax; (2) Roth; or (3) after-tax.
Pre-tax contributions are usually the best bet for a high earner, since they reduce your taxable income and save you money on your taxes today.
Roth contributions are made with post-tax money which means you pay taxes today but will skip paying taxes on withdrawal.
Today we’re most interested in exploring the after-tax contributions.
After-tax contributions are contributions to a 401(k) plan made with post-tax money (like Roth contributions). After-tax contributions will grow in your 401(k) plan tax-free but all of the earnings will be taxed upon withdrawal (of course, your contributions won’t be taxed again as that would be double-taxation).
You can think of these three types of contributions as different sub-accounts inside a bigger account that is your 401(k). Each sub-account is tracked by your plan administrator separately.
Typically, contributing with after-tax money to your 401(k) isn’t a great deal because you won’t get a tax benefit when you contribute or when you withdraw. The only benefit is that the money isn’t taxed while it’s growing, but in exchange for that benefit you give up all the benefits of having a taxable account (i.e. no restrictions on using your money and the ability to tax-loss harvest).
Plus, the worst part of making after-tax contributions to your 401(k) is that you’re converting what would have been capital gains taxes (i.e. the tax on growth in a taxable account) for ordinary income taxes (i.e. the tax you have to pay on growth of after-tax contributions to a 401(k) upon withdrawal). Once you understand the last point, you understand why you’ve probably never heard of after-tax contributions before.
But IRS Notice 2014-54 made everything much more interesting by giving clear guidance that when transferring money from your 401(k) into an IRA, you can divert the after-tax portion to your Roth IRA without having to pay any taxes.
This is important for those that can make in-service distributions (i.e. you can transfer from your 401(k) to IRA while still employed).
Assuming your 401(k) plan allows for both (a) after-tax contributions above the $18,000 annual contribution limit and (b) in-service distributions, you can contribute after-tax money to your 401(k) and then roll it over to your Roth IRA. Viola, the Mega Backdoor Roth IRA.
Example. Larry contributes $18,000 of pre-tax money to his 401(k) plan each year. His plan allows for after-tax contributions up to the maximum $54,000 limit and for in-service distributions. He contributes $36,000 of after-tax money to his 401(k) and then rolls all of his after-tax dollars into his Roth IRA account at Vanguard. Larry has effectively made a mega $36,000 contribution to his Roth IRA.
Eligibility
Now that you understand how the Mega Backdoor Roth IRA works, are you eligible?
The answer is probably not, but it’s worth checking.
Step 1) The first thing to do is to reach out to your benefits coordinator or get a copy of your 401(k) plan and see if you can make after-tax (non-Roth) contributions above the $18,000 annual employee contribution maximum.
Here’s a look at the language in my plan that makes it clear that the Mega Backdoor Roth IRA is not an option for me:
I suspect you’ll find similar language or a similar answer from your benefits department when you ask. If you are eligible for a Mega Backdoor Roth IRA, please send me an email as I’d love to hear from you. So far I haven’t found a firm that offers this option but I’m hoping there is 1 or 2 out there.
Step 2) If you are able to make after-tax (non-Roth) contributions to your 401(k) plan, the next step is to see whether your plan allows you to perform in-service withdrawals.
If it does, then you’re all set since you can make the after-tax contributions and then immediately roll them to a Roth IRA.
If you can’t, then you have another dilemma to consider. So long as you’re employed, you won’t be able to move the money to a Roth IRA. But, when you leave the job, you will have the option of rolling your 401(k) to an IRA. During that rollover, you can allocate the pre-tax money to a Traditional IRA and the Roth/after-tax money to your Roth IRA. So, if you’re planning on leaving in the near future, you might find it more palatable to make those after-tax contributions knowing that soon you’ll be able to move it to a Roth IRA.
Here’s a few other things to consider:
(1) You can still make your $5,500 Backdoor Roth IRA contributions. These are made via making a non-deductible contribution to your Traditional IRA and then rolling the money to a Roth IRA, so the Mega Backdoor Roth IRA has no impact (despite having a similar name).
(2) If you are married and both of you have cooperative 401(k) plans, you can put up to $72,000 a year into two Roth IRAs!
Summary points
Feeling lucky today? Reach out to your benefits coordinator and ask:
- Does my plan allow non-Roth after-tax contributions and, if so, how much can I contribute; and
- If it does, can such contributions be distributed while I’m employed (i.e. “in-service distribution”)?
Joshua Holt is a practicing private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He spends 10 minutes a month on Personal Capital keeping track of his money. He's also exploring real estate crowdfunding platforms like Fundrise which are open to both accredited and non-accredited investors.
In the last three weeks my employer announced a change to allow after tax 401k contributions. I’m not yet in a position to take advantage of it but thanks for the advice, it motivates me to at least find out about in service rollovers.
Thank you. This is just the article I was looking for. Let’s say I contribute $10k of after tax dollars to my 401k. It then grows to $11k. Can I rollover the full $11k to my Roth IRA tax free and then at retirement withdraw all $11k tax free? Or will I at some point pay taxes on the $1k of gains?
Have you had any luck finding a 3rd party administrator offering non roth after tax contribution long with in service distribution. I want to open a SOLO 401k on contribute the max allowed . Thanks
No but this isn’t something that I’ve looked into before. I know Fidelity offers it in their 401(k) plan but not sure if it’s available in their solo 401(k) plan. Have you been looking around and not finding anything?
I found an administrator mysolo401k.com that prepared all the docs and Fidelity will hold the funds in 2 accounts, It cost $550 to set up and $125 per year thereafter. This company was lightning fast and seemed very knowledgeable. Now I can put an additional $37000 into my roth 401K for 2019. Seems to good to be true but I reviewed everything and feel it has been done correctly.
I’ve heard of mysolo401k.com before. Sounds like a great option. Glad to hear you’ve got it set up and running!
I recently learned that my v50 allows for after-tax contributions to the tune of $37,000 and also allows in-service distributions to a Roth IRA. FWIW, I think it’s getting quite popular, as a couple other friends’ biglaw firms also allow for it.
Say that I’m about to be a 26 y/o second year associate, and that I have ~$170k debt recently refinanced to a 3% fixed rate, 5 year term with lots of excess cash every paycheck. I’m already maxing my pre-tax 401(k), my backdoor Roth, and my HSA.
What do you recommend doing with the excess cash? I know that you generally prefer prepaying debt versus taxable investments, but to what extent does that calculus change with tax-free growth?
Further, to what extent does that change given the VERY flexible ability to withdrawal principal from the Roth IRA (even within 5 years of the conversion) without penalty? I imagine that I could MBDR funds into my Roth IRA, hold them quite conservatively in short-term bonds (if not even more conservatively) for the next few years, and pull the principal as needed to pay off loans early or otherwise supplement a lower-paying job post-biglaw. To the extent that I pull principal, then it seems that there’s no harm besides perhaps a small differential in the guaranteed loan rate of 3% versus whatever my conservative investment made over those couple of years. To the extent that I don’t pull principal, I end up stuffing a tax-advantaged space that can grow for another ~40 years. Would love to hear your thoughts.
That’s great news. I agree that it’s becoming more common in Biglaw to allow for the Mega Backdoor Roth, but I still think you’re in the minority. I hope that won’t be the case for long though!
I agree with you that being able to put money into a tax-free growth account such as the Roth IRA changes the calculus in the perpetual should-I-invest-or-pay-off-debt debate. If I had access to that when I was paying off my debt, I would have maxed out the Mega Backdoor Roth IRA like you’re proposing with a strategy similar to yours (invest conservatively to ensure that I could withdraw the principal if needed). I think you’ve covered all the downside risks while making the smart decision to get as much shoveled into tax protected accounts as possible.
The only thing I’d possibly add is to not let this plan let you slack off on paying down the debt. Granted, your funds may be pretty stretched if you’re a first or second-year associate who is maxing out a pre-tax 401(k), backdoor Roth, HSA and mega backdoor Roth, but you’ll be doing yourself a world of good if you still do what you can to chip away at the debt. I say this only as a reminder that paying down debt isn’t nearly as fun as watching a bank account grow but is, of course, a necessary evil.
Let me know how this plan goes!
As best I can tell, my firm does not yet allow the mega backdoor Roth because it doesn’t allow in-service distributions. However, it does allow after-tax contributions to the plan, as well as in-plan Roth conversions.
Would I be able to 1) contribute the $19,500 pre-tax, 2) contribute an additional $37,500 after tax, and then 3) convert the after-tax contributions to Roth? Seems like I’d have to pay income tax on any gains made between contribution and conversion, but other than that I’m not seeing any major issues. And it seems like a better place to park that money than a taxable investment account since I’m already maxing out my 401(k) and backdoor Roth contributions.
Hi, Josh, does it matter how to apportion the percentages across the accounts if I want to max out all my contributions? I need to set % for each of 1) 401(k); 2) Roth 401(k); and 3) after-tax accounts (since my firm’s plan allows this). Do I contribute evenly across the accounts (75%/3 = 25%)? Thank you!
Hi Josh, if I have an option to do either 1) Mega Backdoor Roth IRA or 2) Mega Backdoor Roth 401(k), which one should I do? To do the MBR IRA, I’d have to fill out paperwork every 2 weeks (as I’m paid semi-monthly) but if I do MBR 401k, the rollover is automatically managed by the administrator. Should I still go for MBR IRA notwithstanding the inconvenience of filling out forms every 2 weeks?