Mega Backdoor Roth 401(k) In Plain English
It’s taxing to learn, but it’s worth it.
You probably have heard of Roth 401k, its tax-free earnings, and $19,500 limit per year. But did you know it’s possible to stash an additional $38,500 into your Roth 401k each year, given your employer provided the right plan? I certainly did not know, and it took me a significant amount of time to comb through dozens of articles filled with jargon in order to make sense of it. Because of this, I decided to share my notes in case it benefits another curious soul.
Why Roth 401k and Why Mega Backdoor?
You probably are familiar with how a traditional 401k (Sometimes referred to as pre-tax 401k) works and how it helps lower taxable income — You put pre-tax dollars (typically referred to as “contributions”) in it, these pre-tax dollars then generates extra dollars (typically referred to as “earnings”) over the years via investment. However, upon withdrawal at retirement, you’ll need to pay tax for both the contributions and earnings, this is called tax-deferred. So here is where Roth 401k differs — The contribution you make to a Roth 401k has to be after-tax dollars, so when you withdraw upon retirement, you don’t need to pay taxes for your gain. All the earnings you’ve accumulated over the years are essentially tax-free. That sounds so nice, doesn’t it? But here is the catch: There is a total limit of $19,500 each year for traditional and Roth 401k combined. And that, is what leads to all the hype surrounding Mega Backdoor Roth 401k.
So what is Mega Backdoor? To explain that we have to first introduce the third (!) kind of 401k — after-tax 401k. Very similar to Roth 401k, the money we contribute to an after-tax 401k is also after-tax income (Duh!). However, the earnings in an after-tax 401k are not tax-free, but tax-deferred. Despite this, you can take a step further and convert contributions to an after-tax 401k to a Roth 401k before any earning is generated. Voilà! Now you’ve got extra money in a Roth 401k that grows tax-free! This conversion from an after-tax 401k to a Roth 401k is usually referred to as an in-plan conversion. And this niche strategy of taking a detour through an after-tax- 401k before ultimately reaching a Roth account is named Mega Backdoor.
+------------------+------------------+--------------+
| 401k | Contribution | Earnings |
+------------------+------------------+--------------+
| Traditional 401k | Pre-tax dollars | Tax deferred |
| Roth 401k | After-tax income | Tax free |
| After-tax 401k | After-tax income | Tax deferred |
+------------------+------------------+--------------+Do I need it?
If you have not maxed out the $19,500 limit on a pre-tax 401k yet, please consider that first. However, if you are a high earner or a heavy saver, and if you won’t need the money you saved for a long time, it’s probably worth exploring this mega backdoor option.
What’s required for setting it up?
As described in above, there are a few essential parts that have to be provided by your employer’s 401k plan:
- First, the plan has to allow after-tax 401k contribution — This allows you to put money in to prepare for the next step.
- Second, the 401k plan needs to allow in-plan conversion — This allows the after-tax 401k to be converted to Roth 401k before generating earnings. Depending on different providers, the enabling of this feature could be different. For Fidelity, this feature needs to be enabled by calling customer service, but it’s pretty-much hands free after that. The advantage of setting it up as an automatic process is that there is no concern over accumulating earnings prior to conversion that leads to taxable capital gain.
How much could I put away?
In 2021, the total limit for 401k contribution is $58,000 per year. As an example, if you have maxed out your Pre-tax 401k ($19,500) and your employer matched $6,000, then the after-tax dollar amount you can contribute is $58,000-$19,500-$6,000, which is $32,500. That means $32,500 for investment without tax for gains, how sweet is that? 🍠