Mega-Backdoor Roth - The Hidden 401k Feature that can Supercharge Your Retirement Saving

Saying that the Mega-Backdoor Roth strategy can supercharge your retirement saving is not a hyperbole. In most situations, maximizing this feature MORE THAN DOUBLES the amount you can save to Roth accounts each year. Once those savings are invested in a Roth account, they can grow tax free for years or decades and be withdrawn tax free* in retirement.

The “mega-backdoor” can have mega tax impacts

A quick example illustrates just how powerful those tax savings can be:

Each year for 20 years, “normal 401k Charlie” maxes out his Roth 401k with $20,500 and invests an additional $40,500 in a taxable investment account. Both accounts grow at 6% per year. At the end of 20 years, Charlie has $1,497,169 in his taxable account and $757,826 in his 401k; $2,254,995 in total. While Charlie’s Roth 401k savings can be withdrawn tax free in retirement, he will owe capital gains tax on the $687,169 of his investment gains in the taxable account. At long term capital gains rate of 15% that would be $103,075 in taxes! This doesn’t even include taxes he would likely have paid on dividends in the taxable account over 20 years.

“Mega-backdoor Bettie” on the other hand maxes out her normal $20,500 Roth 401k contribution and is able to invest an additional $40,500 into her Roth 401k through the Mega-backdoor strategy. After 20 years, with the same investment return as Charlie, Bettie has the same total savings of $2,254,995. However, Bettie can withdraw that full amount tax free in retirement.

In this example the Mega-backdoor saved Bettie $103,075 on taxes! She also didn’t pay tax on any dividends along the way.

How to implement the Mega-Backdoor strategy

Hopefully this example helps illustrate that the Mega-Backdoor Roth can be a powerful tax-saving strategy, but how does it work? By making after-tax 401k contributions and in-plan Roth conversions. Let’s break those two steps down:

1) Allowing after tax 401k contributions increases the maximum amount employees can contribute from $20,500 in 2022 to $61,000* (or $67,500* if you’re over 50). After-tax contributions don’t reduce your taxable income or tax bill today, but this is where the in-plan Roth conversion is key.

2) Through an in-plan conversion you can easily take those huge after-tax contributions and convert them to Roth funds within your 401k (or through rollover conversions to a Roth IRA). Once converted, your savings grow tax-free and can be withdrawn tax free in retirement just like normal Roth 401k or Roth IRA contributions.

This is the power of the mega-backdoor, it allows you to quickly build a much bigger tax-free* retirement nest egg than you could with a typical 401k and Roth IRA alone. And, unlike a Roth IRA where households over the income limit aren’t allowed to contribute, anyone in the plan can contribute with no income cap. This means even high earning households can mega-backdoor. It’s actually this group that can benefit the most!

Some 401k plans don’t support the Mega Backdoor and some require an extra step

Unfortunately, many 401k plans don’t allow allow for employees to make after tax contributions. Sadly, there’s not even a good reason for this other than perhaps some added administrative difficulty. That said, it is becoming more and more common and will likely continue to grow in popularity. Some plans allow for after tax contributions but don’t have a program set up for in-plan conversions to Roth. This is where a second step is needed to see if the plan does allow for “in service distributions” so that employees can roll over their after tax contributions to an IRA and convert them to Roth. If you’re unsure what you’re plan allows or how to execute this step please reach out, I’m happy to help.

The Mega Backdoor isn’t right for everyone

Let’s be honest, making mega-backdoor Roth contributions isn’t realistic for a lot of people. Maxing out a $20,500 annual contribution is already a lot! In fact, it may already be more than enough for your situation and retirement goals. That said, there are a lot of unique situations where a mega backdoor strategy can become unexpectedly relevant, I’ve written about several of them here: Mega-Backdoor Roths Aren’t Just for Rich People.

Like any large money decision, mega-backdoor Roth contributions should be part of a bigger financial and tax strategy built around your needs, your timeline, and your goals. If you’d like help building a strategy tailored to your timeline and goals (or figuring out if your employer allows the mega-backdoor), feel free to reach out, I’d love to see if I can help or direct you to someone who can. You can reach me by email at ryan@ffadvisor.com or cel phone: 616.594.6205.

Footnotes:

*Roth savings grow tax-free. Contributions can be withdrawn without tax or penalty at any time and investment gains can be withdrawn tax and penalty-free after age 59-½ (or 55 if the “rule of 55” applies to you).

*$61,000 and $67,500 are the 2022 limits for employee contributions, employer matches, and profit sharing contributions combined. Your max contribution = $61,000 or $67,500 - employer match - profit sharing contribution.

Why I’m quitting a good job, in the middle of a pandemic, with my first kid on the way, to pursue my passion for financial advising

As I began to share with family, friends, and coworkers that I was changing careers to become a financial advisor a common question they asked was, “why?” or “why now?”. I think I knew on some level the answers to these questions but having to actually explain “why” out loud clarified for me what motivated this change and made me more and more confident I was on the right path.

1. I want to be able to see the impact my work has. I truly believe Steelcase and my work there has helped contribute to more inspiring work environments, but it can be hard for that to feel immediate or personal. For me, seeing the direct impact of helping people attain their goals and plan their financial futures will be more fulfilling.

2. Doing something I’m truly passionate about will bring out the best in me. I’m conscientious and hard-working regardless of what I’m doing, but I also know I’m at my best when doing something I really care about and enjoy.

3. I realized I had no control in the corporate world. A lot of people and companies had to do whatever it took to get by in 2020. I think Steelcase handled things as well as they could! But project cuts, people cuts, and being told how many hours you’ll work and where puts your lack of control in the corporate world into clear focus.

4. Change will only get harder. I certainly won’t have more time or energy once kids are part of the equation! That plus inertia makes me believe a leap like this will only get harder the longer I wait.

5. I never wanted to wonder “what if?” 

If I’m honest with myself, there are a lot of “I’s” and “wants” there. In many ways “pursuing a passion” does feel selfish and privileged, especially this year. Because of that I’m even more grateful for a supportive wife who encouraged me to get serious about pursuing this new career when she could have told me to be practical and keep a reliable job with a salary. I’m also thankful for family, friends, and coworkers who have offered encouraging words when they could have discouraged me or rolled their eyes. Thanks for being part of my team!

Lastly, thank-you to Fiduciary Financial Advisors for taking me on… I’m so excited to be joining an independent local firm that is doing things the right way! I never would have made this leap if it wasn’t to join something I really believe in.

Have you made or thought about a big change during 2020? Would be nice to know I’m not the only one!