Roth IRA Part 3 Mega Backdoor Roth

May’s blog rounds out part 3 of our 3-part series on building Roth dollars for high-income households.

In the last two months, we discussed:

1. What to do when your income crosses the Roth IRA contribution limit for the first time and how to avoid any tax penalties associated with excess Roth IRA contributions.
2. How to complete a ‘Backdoor’ Roth IRA contribution using non-deductible Traditional IRA contributions & Roth Conversions and some common pitfalls when doing so.

The last major piece of the puzzle when building Roth dollars for high-income households is actually the simplest, it’s your 401(k). For the sake of simplicity, I’ll refer to 401(k) as a catch-all for other types of employer-sponsored retirement plans including 403(b), 401(a), 457, etc.

The Roth 401(k) is actually a relatively new tool, first allowed in January 2006. We still see several employers of clients who do not yet allow a Roth option. For those that do, the Roth portion of a 401(k) avoids many of the issues that can arise in a Roth IRA including the income limit ($230K MFJ, $140K Single), the relatively low annual contribution limit ($7,000), and the pro-rata rule for Roth conversions.

The difficulty in planning for clients in their 401(k) plans is that all plans are not the same. While all custodians play under the same rules for the Roth IRA, it is actually up to the employer to determine what is offered in a 401(k) plan, including if a Roth option is even allowed at all!! Sometimes plans are limited due to the cost of maintaining the extra options, other times due to regulatory requirements, but in my opinion it is often due to the employer not knowing these options exist. To summarize how incredible a Roth 401(k) can be, let’s go back to our fictional couple John & Jane Smith from last month.

Remember that Jane recently received a promotion, and their household is now over the income limit to make Roth IRA contributions. With proper planning they can continue to make backdoor Roth contributions but that is only $7,000 a year of Roth dollars each and they have cash flow to make more contributions towards retirement.

Jane works for a large company with a very robust 401(k) plan. The plan allows several options that many companies do not. Since Jane is under 50 years old, the max deferral she can make through payroll to her 401(k) is $23,000 in 2024; however, her plan allows after-tax contributions up to the IRS max of $69,000 per year. You read that right, if someone had the cash flow to do it and their 401(k) plan offered the ability to do it, the maximum contribution into a 401(k) plan for 2024 is $69,000. For those of you that enjoy digging into the details, this is called the IRS 415(c) limit which is adjusted for inflation each year.

Quick aside, most are familiar with Traditional and Roth contributions in a 401(k). But many large 401(k)s offer a 3rd option called after-tax contributions. An after-tax contribution is different than the other two, an after-tax contribution is made after-tax like Roth, grows tax-free like both Traditional and Roth, but then distribution of gains is taxable similar to Traditional contributions. It takes the worst parts of both Traditional & Roth, no upfront tax deduction and taxable at distribution, and combines them. So why would anyone make these contributions?? The Mega-Backdoor Roth is why, let’s see how Jane does this in her 401(k).

Jane maxes out her deferral of $23,000 and then starts making after-tax contributions to her 401(k) plan. Note that the 415(c) limit of $69,000 is the maximum amount of dollars that can go into a 401(k) plan from ALL sources, this includes the employer match and any employer profit sharing! Jane is anticipating making $250K from her job and they have a 4% match. That leaves the opportunity for $36,000 of after-tax contributions ($69K max - $23K deferral - $10K employer match). If Jane hits the $69K max before year-end, she will likely lose out on free money from the employer match, so watching contributions through paystubs can be important throughout the year.

Here is where the sauce is made, Jane’s 401(k) plan allows in-service Roth Conversions. For every after-tax contribution Jane makes, her plan allows her to convert those dollars to the Roth portion of her 401(k). This is very similar to the non-deductible IRA contributions and backdoor Roth, only this is done in the 401(k) itself. Because taxes have already been paid on the after-tax contributions, the Roth conversion in the 401(k) is also a non-taxable event as long as done correctly. Also, the 401(k) does not have a pro-rata rule like an IRA so Jane can have pre-tax dollars in the plan. It’s called the Mega-Backdoor Roth strategy because in this scenario Jane is contributing 5X the annual Roth IRA limit.

So, between the Backdoor Roth IRA and the Mega-Backdoor Roth through the 401(k), Jane is putting $66,000 a year into a Roth vehicle!!

Please keep in mind that every 401(k) plan is going to be different depending on how the employer has set up the plan. Sometimes it is up to the employees to advocate for themselves to HR to amend the plan to allow these special features!

This is an extreme example of what’s possible and often is not practical considering lifestyle cash flow needs, tax consequences of high-income households making all Roth contributions, and other financial goals. However, it’s a great example where an advisor who is versed in these financial planning topics can advise and guide on how best to optimize every dollar earned. If you are a high-income household looking to optimize savings for any financial goal, please feel free to schedule a call with our office at 219-465-6924.

Mark Rosinski, CFP®, CPA 

Wealth Advisor 

Please note that this blog is for educational purposes only and Kotys Wealth Professionals does not prepare taxes. Always consult your accountant about your personal tax situation.

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