The Mega-Backdoor Roth Conversion

You’ve likely heard of tax deferred or traditional retirement contributions. And perhaps, you’ve heard of a tax-free contribution or Roth retirement contributions. But have you heard of after-tax contributions?

For most employees, the limit on elective contributions to an employer-sponsored retirement plan is $19,500 (plus an additional $6,500 for those age 50 or older) for 2021, which is the amount one can contribute to a traditional 401(k) or Roth 401(k). But for those with employer-sponsored plans that allow it, employees can make after-tax, non-Roth contributions to fully fund their 401(k) account up to $58,000 ($64,500 for those age 50 or older) for 2021. Then, the employee can either convert those dollars to a Roth 401(K) or, if available, take an in-service distribution from the plan and roll over the money into a Roth IRA. This strategy has become known as the mega-backdoor Roth conversion. Since after-tax dollars are used, tax consequences are minimal.

However, there are two things to be aware of. First, you want to leave enough room within your total $58,000 (or $64,500) 401(k) contribution level so that you do not crowd-out any employer contributions. So if you otherwise were determined to fully fund your 401(k) and your employer was making a matching contribution of $2,000, you would only want to contribute just enough of an after-tax contribution to allow the account to reach the fully funded amount of $58,000 (or $64,500). So think of your 401(k) as a $58,000 (or $64,500) bucket made up of your elective contribution, catch-up amount (if applicable), employer matching contribution and after-tax contribution. Second, unfortunately for employees working for nonprofits and schools, government 457 plans and most 403(b) plans do not allow for the after-tax contributions. This option is not automatically available in all 401(k) plans, but well worth inquiring about and considering, if available, when planning wealth-building strategies for retirement needs.        

In building your Roth retirement accounts, don’t ignore, for those who qualify, contributing directly to your Roth IRA. For those whose income disqualifies them from contributing directly to a Roth IRA, consider where the backdoor Roth IRA strategy makes sense; this is not the same as the mega-backdoor Roth conversion. For this strategy, one is allowed to make a non-deductible contribution (after-tax money) to a traditional IRA up to $6,000 ($7,000 for those age 50 or older), then convert that contribution to a Roth IRA. Since after-tax dollars are used, tax consequences are minimal. 

For both strategies above, it is best when an account holder can convert their after-tax contributions soon after making them, pay income tax on any earnings, and then convert the contribution to a Roth IRA or Roth 401(k) where it can grow tax-free.

For those with high-deductible, employer-sponsored health insurance plans, consider contributing the maximum amount to a health savings account (“HSA,”) which is a tax-advantaged account. The contributions to the HSA are deductible and the distributions, when covering medical expenses, are not taxable. Contributions in 2021 for single coverage is $3,600 and for family coverage is $7,200. For those age 55 or older, you can add an additional $1,000 to contributions.

For purposes of wealth accumulation during your income-producing years, weigh all of your options when considering the use of tax-advantaged accounts and speak with a tax professional if necessary.