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 former 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 Empower keeping track of his money. He’s also maxing out tax-advantaged accounts like 529 Plans to minimize his taxable income.
