Have you maxed out your backdoor + mega backdoor Roth conversions yet?
For high earners, direct contributions to a Roth IRA, and tax-deductible contributions to a traditional IRA, are limited by income thresholds.
But ALL taxpayers – even high earners – can still invest money into a Roth via backdoor Roth conversion. And if your employer’s 401k has the right plan features, you can turbo-charge your Roth conversions another 7x by doing the “mega backdoor” Roth conversion.
What the heck do these mean? And how exactly do you do them?
This week, I share what these concepts are, tips for how to execute them successfully, and what you need to know about your employer 401k to turbo-charge your Roth conversions.
- The difference between a backdoor Roth vs. mega backdoor Roth
- How to execute each one + tips to ensure no tax liability when you convert
- What plan features your employer 401k must have to do a mega backdoor Roth
- Workaround if your employer 401k does NOT allow in-plan Roth conversions, but DOES allow after-tax contributions (yes, you can still move that money into Roth)
- How recent proposed legislative changes would curtail the backdoor Roth strategy, and whether you need to worry about it
- A note about doing mega backdoor Roth conversions via Solo 401k.
Have you done a backdoor or mega backdoor Roth conversion before? If you’ve decided not to, what dissuaded you? Let me know by leaving a comment.
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- Traditional vs. Roth? How to double-dip on the tax benefits of BOTH
- What is a Solo 401k? And Why It Beats All Other Retirement Accounts
- Everything you need to know about 401Ks (HYW003)
- IRAs, Roth IRAs, and how to get the tax benefits of BOTH (HYW004)
- Schedule a private 1:1 consultation with me
- HYW private Facebook community
Read this episode as a post:
The topic today that I really want to talk about is the backdoor Roth and the mega backdoor Roth as a strategy to help accelerate your retirement and FIRE goals. So, I want to spend some time talking about exactly what is a backdoor Roth.
Many of you are probably already familiar with it, but I really want to get into the nuts and bolts of what it is, the mechanics of how to do it, how to find out if you can do a mega backdoor Roth (and we’ll explain the distinction between regular backdoor and mega backdoor) through your employer, tips and strategies when you do the conversions, and also what options you might have if your employer does not provide a mega backdoor option.
The mega backdoor Roth, which is what I want to spend the bulk of the discussion today on, is one of the most powerful levers that people who still are currently working normally W-2 jobs, but it could also apply to people who are running their own businesses and have a solo 401(k). it is one of the most powerful levers that you have to accelerate after-tax retirement savings, so that it can compound and grow and eventually be taken out tax-free.
That’s why it’s important and why I want to dedicate an episode specifically on backdoor strategies.
So, to kick things off, I want to first talk a little bit about what exactly is a backdoor Roth. A backdoor Roth, in a nutshell, is the idea that you take money that’s sitting inside of a traditional retirement account—401(k), 403(b), an IRA, etc.—and you convert that money into a Roth version of that same account, so that the future growth of that money can grow and compound tax-free, and then be taken out tax-free at retirement.
The idea of a Roth conversion may not be anything new, but the extra feature of a backdoor Roth strategy and a mega backdoor Roth strategy (they’re just two different flavors of the same strategy) is that you can effectively contribute not only to a Roth account, even if you would otherwise be ineligible due to income limits…
…but with a mega backdoor strategy on top of that, you can actually contribute way more than you would otherwise be able to, even if you didn’t bust the income limits for contributing to a Roth IRA.
So, that’s the idea in a nutshell. It’s just a way for you to contribute lots of money to a Roth IRA, even if you were otherwise ineligible due to income limits. I’m going to bookmark that and come back to some more detail and the mechanics on that in a moment, but I want to first spend some time talking about the landscape of the different types of retirement accounts and how the backdoor eventually fits into that.
As you probably know, Roth accounts, regardless of whether you’re talking about an IRA or a 401(k), a Roth version of those accounts has, by far, the best tax profile once the money is inside the account, because there’s no tax that is imposed on either the growth of the account over the years or on the withdrawal of money from the account at retirement.
Pre-tax accounts, by contrast, whether you’re talking about IRAs or regular 401(k)s, they do give you a good benefit upfront in that you can take a tax deduction at the time that you contribute. And they also don’t tax growth or activity inside the account over the years. That’s good.
But when it comes time to withdrawal, you will get taxed on the entire amount of your withdrawal, both principal and capital gain, and you’re going to get taxed at full ordinary income tax rates. So, that’s the worst of all possible worlds because you’re not only getting taxed at withdrawal, but you’re getting taxed at ordinary rates. There’s no capital gain benefit from that.
So, a key tax and retirement planning objective for any retiree, any saver, is how do you get more money into a Roth account? Especially if you’re a high earner and you’re otherwise locked out of direct contributions, how can you get money at all into a Roth account, and how can you get more money into a Roth account?
And if you have a long time horizon until retirement, say anything more than 10 years, it is purely beneficial to you to get more money into a Roth account sooner. So, this just has longer time to compound tax-free and grow larger tax-free, so that at retirement, you have the ability to withdraw more retirement savings tax-free.
I’ve written in the past before in the Hack Your Wealth blog about how the best strategy really blends the two, where you contribute to a traditional pre-tax account first, take the tax deduction benefit upfront, and then later slowly amortize Roth conversions to move money over to Roth. I’ll link to that article in the show notes, for folks who are interested in checking that out. And I still stand by that strategy.
But that article didn’t talk really about how to actually execute a backdoor Roth conversion plan, and certainly not the mega backdoor Roth, so that’s what we’re going to focus on today.
The problem is, especially if you’re a high earner, contributing to a traditional Roth IRA account actually isn’t very easy because there are income phase-outs at relatively low income levels. Also, the amount that you can contribute to a Roth IRA, or a regular IRA, is pretty low. It’s capped at a few thousand bucks.
If your employer offers an employer retirement plan, like a 401(k), 403(b), any of these types of retirement plans, you can contribute a little bit more than you could to an IRA, regardless of whether it’s Roth or traditional. For an IRA, you can only contribute a few thousand dollars, but to an employer retirement plan, you can contribute generally a little bit more than three times that amount, a little bit more than $20,000 at the time of this recording.
It’s still capped at a relatively low level. A little bit more than $20,000 is better than a little bit more than a few thousand dollars, for sure, but you can actually do even more than that with a backdoor, and especially a mega backdoor Roth strategy. So, that’s where the backdoor strategy comes in.
In terms of the mechanics of how to do a backdoor Roth conversion, regardless of whether you’re converting from an IRA or a 401(k), as I’ve alluded to, there are two flavors of this: there’s a regular backdoor strategy, and there’s a mega backdoor strategy. You can do one or the other, or you can do both. I haven’t actually done both every year.
When you get into the details, the regular backdoor strategy essentially consists of making after-tax contributions to an IRA, so you’re still capped at a few thousand bucks. Right now, I think it’s at $6000 at the time of this recording. You make after-tax contributions to a regular IRA in the amount of, say, $6000 (the current cap), and then you convert that money immediately into a Roth account.
With a mega backdoor strategy, you’re making after-tax contributions to your 401(k) or your employer plan, and there the caps are much higher. So, even though your individual employee contribution is capped at a little bit more than $20,000 (I think right now it’s $20,500), the combined cap for both employer and employee contributions is actually, as of right now, $61,000.
So, you can imagine how, if you contribute after-tax dollars into your employer retirement plan, like a 401(k), you max out your first $20,500, and then you contribute after-tax dollars for the remainder up until the $61,000 cap, you can then convert all that money into Roth, and you can do that every year. And the caps generally increase every year, or every other year.
The mega backdoor strategy is powerful in this way because it’s 10 times larger than your contribution caps for an IRA: $61,000 versus $6000. So, it can highly accelerate your accumulation of after-tax dollars.
Now, there have been recently some proposed legislative changes to potentially get rid of the ability to do backdoor Roth conversions. It didn’t pass Congress in the first round of proposed legislative changes. As of the time that you’re hearing this, at the time of this recording, it probably won’t come to pass for a while…
…given now there’s just a lot of other things going on in the economy and in global international relations that reforming the tax code right now as part of a broader package of congressional legislative changes is just probably not going to be the highest priority for the president, for Congress, etc. So, we’re probably safe for a little while, but it could come back.
This is not the first time that there have been legislative proposals to close the ability to do backdoor Roth conversions. But as of right now, you can still do it. You should definitely take advantage of it.
So, how do you actually do this? We talked a little bit about both flavors. For the regular backdoor strategy, I’ll just briefly talk through the mechanics of that, and then I’ll spend most of the time talking about the mega backdoor through your employer.
For the regular backdoor strategy, no matter the income level, even if you make millions of dollars a year, everybody is allowed to contribute to a regular IRA on an after-tax basis. If you make below a certain income threshold, you can actually contribute on a pre-tax basis and take a tax deduction. But everybody can contribute, at least on an after-tax basis, in the amount of up to $6000.
So, it’s just the character of that contribution, whether it’s pre-tax or after-tax, is going to be driven by your income level. But no matter how much you earn, everybody can contribute at least $6000. And if you’re a high earner, you would just contribute after-tax dollars up to $6000 in a regular IRA.
The moment you contribute that money, you simply convert that money into a sibling Roth account. And if you do it right away, and if your contribution was using after-tax dollars, there will be no tax consequences, because you’ve already paid taxes on that contribution and you haven’t invested in anything yet because it just hit your account. You just contributed.
So, if you convert it right away, right after you make the initial contribution, there will be no growth in that contribution, and therefore, there will be no tax consequences. Once it’s in your Roth account, you can then invest it, and it will grow tax-free forever and won’t have any taxes taken out when you withdraw. That’s the mechanics of the regular backdoor.
For the mega backdoor, let’s talk a little bit about how you do this. First of all, it’s important to figure out, to find out if your employer even has the ability, do they even have the mechanism in their retirement plan to support this? To do this, you would call or email your benefits person, or your plan administrator, or your benefits department.
Certainly not all employers offer the ability to do a mega backdoor Roth conversion. Not even all of them allow you to do after-tax contributions to your retirement plan or your 401(k). It’s actually relatively rare that employers have a mega backdoor Roth conversion option.
Several of the large tech companies do have this. And to actually execute a mega backdoor Roth, you’re going to need a 401(k) plan, or a 403(b) plan, or a similar type of retirement account that’s sponsored by your employer. For these purposes, I’m just going to lump them all together and consider them all 401(k) plans, just so it’s easier to explain.
But you’re going to need a regular 401(k) plan. You’re going to need a Roth 401(k) option inside of your plan, so that you can have both traditional and Roth versions of a 401(k).
You’re going to need an after-tax 401(k) contribution option. Not all employers have to provide this. Many of them do, but they don’t have to do it.
And then you’re going to need a feature inside of your employer retirement plan to convert money from your traditional account to a Roth account. And that’s the one where relatively few companies allow it, or support that in their plan. Some of them do; a bunch of the large tech companies do.
So, to find out whether your plan offers this, you just have to call or email your benefits department to ask.
Assuming that your 401(k) plan does provide all of the raw ingredients needed (traditional account, Roth account, after-tax contribution option, and ability to do in-plan conversion), assuming that your company does support all of these things, then the mechanics are actually very similar to doing a regular backdoor conversion.
You would contribute, first of all, up to your employee contribution cap, which is right now $20,500. That you could do pre-tax or after-tax directly. You don’t have to do any conversion for that one.
And then, after you max out your employee portion of your contribution, after you max out that $20,500, you still have a bunch left before you hit the $61,000 combined cap for employee and employer.
Now, many employers provide some kind of matching benefit, like if you contribute to your 401(k) plan, your employer might match a little bit of it. That’s going to get clubbed in together to add up to that $61,000.
And if your employer is matching, it’s always considered pre-tax; it’s never considered after-tax. So, you don’t have any control over that one.
But anything that your employer does not match, any leftover allowance that you still have between maxing out your $20,500 plus any employer matches, anything left to bridge up to $61,000, if your employer allows it, you can contribute after-tax money from your paycheck into your 401(k) plan until you hit that $61,000 cap.
As you contribute that after-tax money, you can convert that money into Roth, so it flips over to your Roth 401(k). And it is no different than if you had taken that money as it was paid to you in your paycheck and walked it over and made a direct contribution to a Roth account. The only difference is that you did this hop in between, where you contributed after-tax money to a traditional account, which, outside of doing a backdoor strategy, has no benefit.
You contributed after-tax dollars, and then you immediately flipped it over into Roth. That is the mechanics of how a mega backdoor strategy would work.
By doing this, you’re essentially able to contribute up to more than $40,000 in Roth contributions through your 401(k) plan, because you can contribute $20,500 upfront, and you can do that pre-tax or directly into your Roth.
And then you can contribute another $40,500 above and beyond that. Again, combination of individual after-tax contributions or employer matches. Even if your employer doesn’t match, the point is that you can contribute tens and tens of thousands of dollars into a Roth effectively in this way, even if your income is too high to otherwise qualify for direct Roth contributions.
So, I want to talk a little bit about tips for when you convert, so that you don’t screw this up. The first thing is that you should not be investing in any securities, any stocks or bonds, until after you make the backdoor conversion. You should be converting as cash.
That is because it guarantees that there’s no capital gains, and therefore, no taxes that are imposed. So, you wouldn’t, for example, want to make an effort to ask contribution and then do something silly, like have it automatically go invest in some fund in your 401(k) plan, maybe have automatic contributions that make automatic investments. You’d want to make sure that that isn’t happening for your after-tax contributions, and instead, when the contribution lands as cash, immediately convert after that.
Now, if your employer offers the ability to do a mega backdoor Roth anyway, then they may have an automatic feature where you can just check a box and then your 401(k) plan will automatically take care of the conversion for you, so that you don’t make that mistake. But if your plan doesn’t have that automatic feature, set a calendar reminder or whatever, so that you remember to not invest that money before you convert it.
Related to this is you should do the conversion right away. The moment the after-tax contribution lands in your account, within a day of it hitting your account, go log in and do the conversion right away. And that’s just to help protect you from doing something silly, like investing it, because once you invest it, if there’s gain on it, now you’re paying ordinary income tax rates on that gain.
When it comes to doing the conversion, there’s no limit on how much you can convert. If you had $2 million, you could convert all of it in one fell swoop, but then you’d better be really sure that you don’t have capital gains on that $2 million. Otherwise, you’d get a nasty surprise come tax filing time.
So, there’s only limit on how much you can contribute, not on how much you can convert. They’re distinct events. The contribution is what’s throttled, and not the conversion.
As I mentioned, at the time of this recording, it’s $61,000 combined for employee and employer contributions in 401(k) plans, but for IRAs, it’s only $6000. So, that’s 10x for 401(k) plans per year, which is what makes it so attractive. That’s why it’s called a mega backdoor Roth conversion strategy.
And that is also why the most critical thing you need to execute this strategy is the ability to make after-tax contributions in your employer-sponsored 401(k) plan. You actually need a 401(k) plan to do this. You need an income to do this, and you need enough income that you can actually pack in that substantial savings each year into your 401(k) plan.
So, I’ve talked a little bit about the best-case scenario where the employer not only provides both the traditional and the Roth accounts, but also provides the ability to contribute after-tax dollars and the ability to convert all in-plan. But what options do you have if your employer does not provide an in-plan conversion option?
If your employer doesn’t provide an in-plan conversion option, but for some reason, they do allow you to contribute after-tax dollars to your 401(k), it’s a little bit of a weird scenario, but it’s possible. I’m sure there are employers out there who have it set up this way. Then what you would do is, since you now cannot do an in-plan conversion, you still need a way to do the last bit, which is the actual conversion part.
In order to do that, it involves rolling out to IRAs, and it requires some workarounds, which I’m going to explain here in a moment. Because it involves IRAs, I first want to level set what the transfer or rollover configurations or possibilities even are.
As a general matter, you can roll a traditional 401(k) to a traditional IRA. You can do that.
Second, you can roll an after-tax traditional 401(k) to a Roth IRA. You can also roll a Roth 401(k) to a Roth IRA. Number four, you can roll a traditional pre-tax IRA into a traditional employer-sponsored 401(k).
Those are basically the different configurations that are possible: traditional 401(k) to traditional IRA, after-tax 401(k) to Roth IRA, Roth 401(k) to Roth IRA, and traditional pre-tax IRA to traditional 401(k).
The one thing you cannot do is transfer from a Roth IRA into a Roth 401(k) that’s sponsored by your employer. That’s a little bit outside the scope of this conversation anyway because you’re not really looking to do that, but I just want to make sure you understood what are all the configurations of transfers and rollovers possible.
And again, as I’ve mentioned earlier, for my purposes, in this whole discussion, I’m using 401(k) loosely to also include things like 403(b) plans. And these types of retirement plans are sponsored by your employer. They all basically have the same rules and restrictions when it comes to transfers and rollovers.
Another thing I want to touch on, before we get into the mechanics of how to execute a one-two strategy of rolling out to an IRA, is to talk a little bit about the differences between 401(k)s and IRAs, because there are some important distinctions that you should be aware of as you do any kind of backdoor strategy.
First thing is that in an IRA of any type, regular or Roth, your investment choices are probably going to be better than you have in your 401(k) plan. You’ll have more options; you’ll have more control. There will just be more things that you can invest in and do with your money.
So, one good benefit of doing a backdoor conversion strategy or a mega backdoor conversion strategy and then rolling out to a Roth IRA is, if you want more investment choices and you don’t want to be bound by the few fund options that are inside of your 401(k) plan, you can roll that money out into an IRA and get more investment options. You can basically invest in anything in an IRA.
The second thing concerns RMDs (required minimum distributions). Roth IRAs have no RMDs. You’ve already paid tax on it; the government is not going to tax you again on it.
But traditional 401(k)s, traditional IRAs, and even Roth 401(k)s do have RMDs once you turn 72. Unless, for some reason, you’re still working at that time, then the RMDs are temporarily suspended until you stop working. But you better really love your job in that case if you’re working that long.
So, one consideration just to be aware of is that 401(k)s of any type have RMDs, and traditional IRAs also have RMDs, but Roth IRAs do not.
One thing that is also helpful to know is that 401(k)s have better creditor protections. In the case of if you owe a lot of debt or you declare bankruptcy, creditors cannot access money inside 401(k)s, whereas with IRAs, there is a way for them to do that.
And 401(k)s are also shielded from bankruptcy proceedings, so you won’t lose 401(k) money if you need to declare bankruptcy. I’m not sure why you need to do that if you’re a high earner and you’re looking to FIRE anyway, but it’s just something to keep in mind. They can access IRAs; they cannot access 401(k)s.
So, with that context in mind, if you have after-tax contributions in your traditional 401(k), 403(b), your employer retirement account, you can roll over those after-tax contributions to a Roth IRA with no tax consequences, which essentially gives you an alternate pathway to do a mega backdoor Roth conversion. But there are some rules that you have to follow to make that work.
The catch is, one of those rules is that you have to roll over pre-tax 401(k) contributions in a proportional amount based on what is actually in your 401(k) account. You cannot just roll over after-tax money only; you also have to take with you pre-tax money. So, it can complicate things.
Let’s use an example to make this concrete. Let’s say your 401(k) has $100,000 in it. 10% of that ($10,000) consists of after-tax contributions, and 90% of it ($90,000) consists of pre-tax contributions.
For these purposes, just to simplify things, let’s say you’re just holding everything in cash. If you are not holding everything in cash, like if you had already invested some money in some 401(k) funds inside of your plan, any gain on that would all be considered pre-tax. Only the contributions can have the character of being after-tax.
So, again, just to simplify, let’s say there’s no gain, you only have contributions in there, and it’s 90% pre-tax, 10% after-tax, $100,000. Now, when you roll over money out of the 401(k) plan because you want to take it to an IRA, it does not matter if you’re doing a full rollover of the entire account, or only a partial rollover of just some of the account.
No matter how much you roll over, 10% of your rollover is going to be after-tax, and 90% of your rollover is going to be pre-tax. That’s because that was the composition of pre-tax and after-tax that existed in your account to begin with.
So, the implication is that the only way to roll over all of your after-tax contributions into a Roth IRA is to simultaneously roll all of your pre-tax contributions over into a traditional IRA. This is similar in concept to the pro rata rule for doing Roth conversions, if you’ve ever done Roth conversions of any type. You can Google if you’re not familiar with the concept of the pro rata rule, if you’re curious.
But the gist is that the conversion, the distribution, rollovers of this nature always happen pro rata based on what is pre-tax versus after-tax. So, in the most straightforward scenario, maybe you roll out your entire balance, your entire 401(k), because you want to take it out to an IRA. Again, this is a scenario where an employer allows you to contribute after-tax, but they don’t, for some reason, allow you to do the mega backdoor conversion directly in-plan.
So, the most straightforward scenario is you roll out the entire balance out of your 401(k) into an IRA. Any after-tax contributions will go into your Roth IRA, and any pre-tax contributions, as well as any earnings of any kind whatsoever from any source, will go to a traditional pre-tax IRA. Those are all considered pre-tax amounts; they’re not the same as your after-tax original contributions.
So, that’s the plain vanilla, easy scenario. You just roll out your entire account.
A more complicated scenario, which the IRS actually allows, is that you can do a partial rollover. You don’t have to roll out your entire account if you don’t want to, but you should know that employers are not obligated to allow you to do partial rollovers. They could force you to either roll out the entire thing or roll out nothing.
So, employers are not required to support partial rollovers in their 401(k) plan. It’s up to them, it’s not a requirement, so you have to check with your benefits department or plan administrator to see if they allow this more complex scenario of doing partial rollovers.
But regardless of whether you’re doing straightforward or complex, when you request the rollover of after-tax funds from your 401(k) to your Roth IRA, your plan administrator is actually going to cut you two checks. One check is going to be for the after-tax contributions, and one check is going to be for any pre-tax money, which is a mixture of both pre-tax contributions and earnings, or capital gain of any kind.
The after-tax check is going to get sent to the Roth IRA custodian, wherever you hold your Roth IRA account. It’s going to get deposited into your Roth IRA account.
Separately, the pre-tax check is going to get sent to your traditional IRA custodian, and it’s going to get deposited to your traditional IRA account. And you’re going to have to designate the appropriate Roth or traditional IRA account in custodian on the request form that you fill out when you request to do the rollover.
So, that’s basically how you can do an alternate pathway for a mega backdoor conversion. If, for some reason, your employer does not allow an in-plan conversion, you can just roll it out to an IRA as needed.
But the critical thing is to do the mega backdoor strategy. That’s the nonnegotiable thing that your employer plan has to have. You have to have a 401(k) plan to begin with.
And they have to allow you to do after-tax contributions from your regular salary. If they don’t allow you to do after-tax contributions, you’re pretty much out of luck. In that case, your only option is to do the regular backdoor Roth strategy, which is to contribute $6000 (or whatever the limit is) after tax, which anybody can do, regardless of whether you’re working or not.
That would be your only option: contribute after-tax, a few thousand bucks to your traditional IRA, and then convert that to a Roth IRA. It’s only when you’re working for an employer, that employer has a 401(k) plan, and that 401(k) plan allows you to contribute after-tax dollars that you have a pathway to do the mega backdoor strategy.
Ideally, your employer plan will have an in-plan conversion option. But in the unfortunate case that it doesn’t, you still have an alternate pathway to roll out that money to a Roth IRA, so that it changes its status from traditional IRA to Roth status.
I also want to touch on the fact that you can also do a mega backdoor strategy using a solo 401(k). I had actually written before about how to set up a solo 401(k) on the Hack Your Wealth blog. I’ll link to that post in the show notes as well.
But it is possible technically to do this with a solo 401(k). But to do that, you actually need the income to make that work. You actually have to have a business that’s a going concern that earns enough revenue to make contributions into a solo 401(k).
They can be employer contributions. They don’t necessarily have to be employee contributions. But the income has to be there, and it has to be enough to max out the mega backdoor thresholds, up to $61,000, for it to work through a solo 401(k).
You can do it through that mechanism, but the key thing there is that you actually need enough income, and of course, you need a solo 401(k).
So, I hope this was helpful, and I hope this clarifies some of the complexities and nuances and confusing parts about how to do a backdoor Roth conversion strategy, especially a mega backdoor Roth conversion strategy…
…and why it’s important and powerful as an accumulation mechanism that has the best tax profile to push as much money into Roth as possible, so that come retirement time, you can withdraw without having to worry about what tax rates are, or how much tax you’re going to owe, or how much extra you have to withdraw to pay the taxes so that you can have enough left over to spend.
So, hopefully, that was helpful. If you like this episode, please consider giving us a 5-star review on Apple Podcasts. We’d definitely appreciate that. It will definitely help other folks find the podcast too.
We will catch you next time. Thanks!