There has been a lot of talk lately about the mega backdoor Roth IRA. For a long time, it was an unspoken secret used by retirement planners. However, the IRS released guidance that specifically addressed both backdoor Roth IRA conversions, and the so-called Mega Backdoor Roth IRA. As a result, it has gained even more popularity and interest.
So what is the Mega Backdoor Roth IRA? The Mega Backdoor Roth IRA allows you to contribute an additional $35,000 into an Roth IRA by leveraging the fact that some employer 401k plans allow after-tax contributions up to the current limit of $53,000.
Wait, what? I thought the Roth contribution limit in 2018 is $5,500 (and $6,500 if you're over 50). How can you contribute over 6x that amount?
Let's dive into a little background, and then show how the process works.
First: Why A Roth vs. Traditional vs. 401k
I think it's important to first have a discussion on why this even matters. Because, for some people, it doesn't matter.
Who This Article Doesn't Apply To:
- If you don't max out your 401k contributions and your IRA contributions currently (this means putting in $18,500 pre-tax to your 401k, and $5,500 to your IRA)
- If you don't meet the income limitations to have a deductible IRA (if you can deduct your IRA contributions, do that)
- If your employer doesn't offer after-tax 401k contributions (you might still want to read this and be in the know, but it won't help you and I'm sorry your employer sucks)
Why Bother With A Roth vs. A Traditional IRA vs. A 401k
Without dragging on a long conversation here, we have an amazing article on when to contribute to a Roth IRA vs. a Traditional IRA. It's a long one, but it goes into detail about the tax consequences of each. I highly recommend you leverage that article as a basis for this.
But honestly, tax diversification is one of the biggest reasons to consider this strategy. It can be benefit to be able to take advantage of both taxable and tax-free accounts in retirement. It *might* also be a benefit to pay any potential taxes today to enjoy tax-free retirement later. It really depends on your tax situation, but if you're already reading this far, you likely know that already.
Background: A Regular Backdoor Roth IRA Conversion
The Backdoor Roth IRA Conversion is an indirect way to contribute to a Roth IRA when you are not eligible to contribute directly due to high income.
Remember, to be able to fully contribute to a Roth IRA, you have to meet the following income limits (as of 2018):
Roth IRA Contribution Income Limits 2018 | ||
|---|---|---|
| Single Filers | Married Filing Jointly |
Phase Out Starts | $120,000 | $189,000 |
Ineligible To Contribute | $135,000 | $199,000 |
If you make more than the income limits, and have earned income, you can still contribute to a non-deductible traditional IRA. The Backdoor Roth IRA uses this tactic to then convert the non-deductible traditional IRA contribution into a Roth account.
Here's briefly how it works in three steps.
Step 1 - Ensure You Don't Have Any Other Pre-Tax IRA Accounts
To avoid many complexities and potential problems, you should eliminate any traditional IRAs, SEP IRAs, or SIMPLE IRAs, unless you are looking to convert those into Roth IRAs. You can eliminate them by rolling them over into an employer sponsored plan, such as a 401k, 403, or 457. This is called a reverse IRA to 401k rollover. You will then be leveraging this employer sponsored plan for the Mega Backdoor Roth IRA.
Remember, you can also only rollover pre-tax money, so any previous non-deductible contributions are not eligible for this.
Step 2 - Make A Non-Deductible IRA Contribution
Once you've eliminated all your traditional IRA accounts, it's time to actually start contributing to your Backdoor Roth IRA. This is the easy part.
Simply open a Traditional IRA Account and a Roth IRA Account at the same firm (you might already have this). Then, contribute $5,500 (the 2017 limit) as a non-deductible contribution to your Traditional IRA.
Step 3 - Convert The Traditional IRA To The Roth IRA
This step is also pretty easy, but there are some caveats. First, you should wait at least one day after the money clears the deposit into your Traditional IRA before converting it. The IRA has no guidelines on this, but it's good to show a clear step-by-step process of how you converted.
For many online brokerage firms make this step pretty easy, but it can be scary. At most firms, you simply transfer the balance from the Traditional IRA to the Roth IRA. That's it. Others might make you sign a form. Almost all will warn you about the tax implications of this, which is the "scary" part of the transaction.
We're fans of TD Ameritrade as our brokerage because they offer no-fee IRAs, and have over 100 commission free ETFs (including popular Vanguard ETFs). Open a TD Ameritrade account here for free.
We're not tax experts, but here's a great guide on how to report the taxes on your backdoor Roth IRA.
How The Mega Backdoor Roth IRA Works
Okay, now that you've had the refresher on the Backdoor Roth IRA, how does the Mega Backdoor Roth IRA work? Well, it takes advantage of the fact the after-tax contributions to a 401k plan are treated just like a Traditional IRA in the above example of the Backdoor Roth.
It honestly just adds one more step to the process. But it requires that you have an employer 401k that allows after-tax contributions. We're not talking Roth contributions, but after-tax contributions.
A note on after-tax 401k contributions. Remember, the IRS limits on total 401k contributions is $55,000 in 2018. That means that you can contribute $18,500 pre-tax, and your employer typically contributes something. Some 401k plans then allow employees to contribute the remaining amount in after-tax contributions.
For example, let's say your employer matches you $6,000 into your 401k. You can contribute $18,500 pre-tax, your employer puts in $6,000, and that leaves you $28,500 that you can potentially contribute after-tax if your employer allows it.
Your 401k Plan Must Meet Specific Criteria To Do A Mega Backdoor Roth IRA
In order to do a Mega Backdoor Roth IRA, your 401k plan needs to offer:
- After-Tax Contributions Above and Beyond the $18,500 Pre-Tax Contribution Limits
- In Service Distributions Or Non-Hardship Withdrawals
If your 401k plan doesn't offer non-hardship in service withdrawals, you might still be able to accomplish the same thing if you're leaving your company soon.
And there is also thoughts that even if you can't do in-service withdrawals, it still might be very worthwhile.
You can then max out your 401k with after-tax contributions up to the contribution limit each year. You can then withdraw that money into a Traditional IRA, and do the same process as a Backdoor Roth IRA.
A Step By Step Process For Doing A Mega Backdoor Roth IRA Conversion
The process for doing a Mega Backdoor Roth IRA Conversion is essentially the same as the Backdoor Roth IRA Conversion, with just two additional steps.
Mega Step 1 - Maximize Your After-Tax 401k Contributions
The first additional step for the Mega Backdoor Roth IRA is that you need to figure out how much to contribute to maximize your after-tax 401k contributions.
This means understanding your employer's plan, and then making the additional contributions. This can be a challenge because many plans require you to specify a percentage of your paycheck, versus a set amount. You also want to make sure that these contributions are AFTER-TAX, NOT Roth 401k contributions.
Mega Step 2 - Withdraw The After-Tax Portion To A Traditional IRA
Once you've maxed out your after-tax contribution, you can withdraw that portion to a Traditional IRA if your employer allows in-service non-hardship withdrawals. Otherwise you need to wait until termination, and you can rollover the after-tax portion into a Traditional IRA.
Once the funds are in the Traditional IRA, the process works the same as the Backdoor Roth IRA Conversion. You just have a lot more money to work with beyond the typical $5,500 annual contribution.
Conclusion
The Mega Backdoor Roth IRA is another potential tool to maximize tax savings IF you have more bandwidth for savings. This strategy is really for people who are maximizing their savings in other avenues first: 401k, IRA, HSAs, 529s.
If you still need or want more tax sheltered savings, then this is potentially a great strategy if your employer allows it.
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Great post. I’ve read about Mega Roth IRAs before. I really like the concept.The only thing stopping me is that I would have to invest the money into one of my employer plans. This sucks for a DGI investor. Having said that, I think this makes sense for me if I know I’m going to leave my employer in a few years. If I knew this, I’d take advantage of this hack and then transfer my 401k over after leaving, buy dividend stocks, etc.
The fact that we need to jump through hoops like this is silly. The Fed should just let investors put as much into a Roth as we desire.
You don’t have to invest for long in your employer’s 401k if you can do in-service distributions. Some plans allow it, others don’t.
As for the standard backdoor IRA conversion, do you need to do a one-time contribution of the full amount, i.e. $5500 or can do you do any sort of dollar cost averaging and just convert as many times as deposits are made?
You can do it as many times as you want in a year, it just becomes a hassle. However, it can help you avoid excess taxes by doing it this way.
It’s my understanding that you don’t have to go the same route as converting to a traditional IRA for the Backdoor IRA when doing a Mega Backdoor IRA because the money is already post-tax. You can just convert the post-tax money to a Roth IRA. Any income made on the after-tax money can be sent to Traditional IRA or left in the 401k as it will be taxed as a traditional Roth IRA income would be. Is this correct?
I don’t think you can convert directly from the after-tax 401k directly to the Roth IRA. You need to have the additional step going to the non-deductible traditional first.
The Bogleheads have a great breakdown on the tax ability of the conversion: https://www.bogleheads.org/wiki/Backdoor_Roth_IRA
That link is for the regular backdoor. You are absolutely mistaken that you cannot go directly to the Roth IRA from 401k After tax. There is no income limit on this conversion when going 401k to Roth IRA, the income limit is on a direct Roth IRA contribution.
You can even split the after tax 401k funds and put those into Roth IRA and put the pre tax (after tax gains) into a traditional IRA. Thus avoiding any taxable event at the time of conversion.
http://www.bankrate.com/finance/retirement/after-tax-401k-rollover-to-roth-ira-rules.aspx
Has anyone performed this successfully with directing after-tax 401(k) contributions to a Roth IRA and the after-tax earnings to a T-IRA or know of this being acceptable with no current year tax consequences? If so, I am a fool for not conducting this with my extra savings if my employer sponsored retirement plan allows in-service distributions with a split single transaction to the IRA types. Is this information false? Would pro-rata rules not allow only the after-tax 401(k) + earnings subaccount to be distributed?
Thanks
Yes, I’ve been doing it since last year. Call Fidelity, ask them for a partial distribution of only after-tax contributions directly to my Roth IRA. I do this once per quarter since they charge me $25 per transaction. I designate my after-tax 401k contributions to a money market fund to ensure no pesky gains during the quarter that the money is sitting there. Easy Peasy. Also, the total 401k limit this year is 54k, vice 53k. (Plus 6k catchup if your 50 or older.)
That’s what I’m wondering also. Do the pro rata rules apply to the Mega Backdoor?
Yes, the pro rata rules apply to the mega backdoor as well.
Thanks for writing such a clear post on this topic. These sort of conversions are interesting, but definitely fraught, if done incorrectly.
Yes, you need to follow the right steps to make sure you do this correctly. Thanks for stopping by!
Based on the IRS website, I believe you cannot roll over ONLY after-tax 401K contributions. Everything has the pro-rata rule applied. See: https://www.irs.gov/retirement-plans/rollovers-of-after-tax-contributions-in-retirement-plans
I believe the only way to do this now is to convert the ENTIRE 401K to multiple destinations — the appropriate portion (pre-tax %) to a Traditional IRA, the appropriate portion (after-tax %) to a Roth IRA. Then, convert the ENTIRE TRADITIONAL IRA back into the 401K so you have an empty Traditional IRA to do the regular $5500 backdoor Roth each year.
Does that sound right?
That is correct – you must take a pro-rata share of after-tax and pre-tax earnings on an in-service withdraw. And yes, you can just send it back to the 401k if your employer allows it.
ENTIRE 401K to multiple destinations —
– the appropriate portion (pre-tax %) to a Traditional IRA
– the appropriate portion (after-tax %) to a Roth IRA.
***- additionally, earnings on after-tax contributions to a Traditional IRA
Hi Robert, great article. Thanks. Why is eliminating a SEP IRA important? How can I learn about the complexities you mentioned?
You have to eliminate other IRA accounts to avoid the IRA aggregation rule. Here’s a great article about it: https://www.kitces.com/blog/how-to-do-a-backdoor-roth-ira-contribution-while-avoiding-the-ira-aggregation-rule-and-the-step-transaction-doctrine/
Thanks, Robert. Very helpful.
Hi Robert, great info.
When is the latest I can move my existing tira into the 401k so I can take advantage of the backdoor Roth for 2016 taxes?
I don’t know if I will need to do a backdoor Roth until next year when my tax preparer does it and does the deductions.
You need to complete everything in 2016. So it really all depends on how fast your brokerage/401k can process things.
Normally when you do an in-service transfer of your 401K to an IRA you do not get to pick and choose which parts transfer. If your 401K assets break down as:
80% pre-tax 401K
15% roth 401k
5% after-tax contributions
Then when you rollover $100K to IRAs they will pro-rate that $100K as:
$80K transfer to rollover IRA
$20K transfer to rollover Roth IRA
I have not seen anyone address the maximum amount of after tax contribution. If someone only has 30,000 of income can they still but in 53,000 into there 401K (with both pretax and after tax funds) or is it limited to wages. I am thinking more about a solo 401k for a schedule C taxpayer in this case.
Your elective contribution cannot exceed $18,000 in 2017, and your employer maximum contribution can be $36,000. If you’re over 50, you can get a catch-up contribution maximum of $6,000.
Theoretically you could earn $30,000, but your employer could contribute the maximum. Some employers off 2 or 3 to 1 matching (although very, very rare).
Robert, Ryan is asking a different question than you are answering.
The employee can contribute $18K or $24K to a Roth 401K. This amount comes from salary paid and cannot exceed W-2 salary. The company can match that 3-to-1 or can make a pre-tax contribution out of company profits at end of year. In the end the total of the employee and company contributions cannot exceed $53K.
Your article is making the specific claim that employees can contribute more than $18K or $24K into an after-tax pool, up to the $53K. Ryan is asking if that money is limited to the amount of salary paid.
Do you have any IRS citation for the claim that employees can contribute up to $53K into an “after-tax” pool within a 401K? Can you supply the name of any 401K administrator who supports such a plan provision? So far I am not having any luck finding this.
The overall limit has been increased to $54K in 2017.
My employer’s 401K allows after-tax contribution to bring overall contribution to IRS limit ($54K in 2017, $60K for age 50+). In addition, it has a web interface (through Vanguard) to do in-plan Roth conversion of after-tax contribution, with just a few button clicks. As soon as my after-tax contribution hits Vanguard, I do the Roth conversion so there is no tax consequence (no gains to tax). Then I have the choice of leaving the Roth money in my 401K, or transferring it to any Roth account I have. I chose to transfer to my Roth at Fidelity, so I can use the full brokerage investment choices. I do this at the beginning of each year, sending 100% of my pay to pre-tax and after-tax 401K, with 0 take home pay until it hits the IRS limit.
Hi Isui
Thanks for your note. I have a 401k with Vanguard and a Roth with Fidelity as well. Can I do transfer of only the Roth portion of 401k (after converting after-tax contributions to Roth like you suggested) to Fidelity Roth without impacting the pre-tax portion of 401k? Most comments here talk about transfer on a pro-rata basis which won’t make sense for me since I already have a large pre-tax 401k amount and don’t want to get into the hassle of moving that around. Sam.
I have a question please:
I am over 60 and I have about 200k in my 401k plan and income exceeds the limit for starting a Roth IRA. I don’t have any IRA.
I woould like to convert 50k into a Roth. Would this work?
Do I need to pay taxes for the 50k?
Thanks,
Michael
Read this article about going from a 401k to a Roth IRA. It’s possible, but requires some additional steps: http://www.goodfinancialcents.com/can-you-roth-ira-rollover-rules-from-401k/
I’m trying to determine if I can get away with this. I think my situation is a little complicated.
My employer allows me to contribute 8% pre-tax and 6% after-tax to my 401k (I’m an HCE and those are the breaks). Years ago before all this came about, I was making after-tax contributions but subsequently stopped and I haven’t for a number of years. I’ve always made pre-tax contributions to the maximum allowed.
I confirmed our 401k plan allows for in-service distributions of after-tax contributions and the portion of the account based on the initial rollover from my previous company.
My 401k has about $400K in it. Of that, about $20K is from after-tax contributions and $20K is from pre-tax earnings on the after-tax contributions – 10% of the overall account.
Now that I’ve learned about this trick I would love to get the after-tax dollars out of there and into my Roth IRA but I think I may be screwed due to the pro-rata requirements on 401k rollovers. Because the overall percentage of my account based on after-tax is low (~5%), I will have to move literally tens or hundreds of $K of pre-tax money at the same time.
Approximately $160K of the account (40%) is based on the initial rollover. 50% ($200K) is based on current contributions. The initial rollover amount represents 44.4% of the overall pre-tax amount. Therefore, due to pro-rata, I can roll over a maximum of 0.444*20K = ~$8,888 pre-tax into the Roth. I’m then left with $160K in a pre-tax tIRA which, hopefully, I can reverse-roll back into the 401k, keeping the standard $5,500/yr back door Roth open.
Questions:
1) Is my take on the pro-rata situation correct? If so, is all this worth the trouble? It’s a lot of money moving around and there will be a certain percentage of time it’s not invested in the market while all these gears are turning.
2) Is it still advisable to re-start after-tax contributions anyway, even if I don’t do the Mega Back Door? The thinking here is that I won’t be with this company forever and at some point I’ll be able to roll it all over the way I want (pre-tax to tIRA, after-tax to Roth IRA) anyway.
FYI: For the time being, I make annual $5,500 back door Roth IRA contributions.
1. It looks correct, but I’m neither your tax advisor or financial planner – I highly suggest consulting with a financial planner in this instance
2. Does your company offer Roth contributions for your 401k (not just after-tax, but Roth)? I would personally go that route instead of all this moving around.
I think the more Roth money you can get, the better, but all of this for $8k more into a Roth doesn’t seem worth it. You can do more going forward.
I can’t figure out how the IRS would know how much in IRA assets a person has. I’m sure there are many folks that have executed a Backdoor Roth conversion and have no clue about the pro-rata rule.
The IRS knows because they get a copy of your Form 5498 every year, where your balance and contribution types are reported to the IRS.
Great post! I have a question regarding my traditional SEP IRA. Does it need to be “hidden” when performing a Mega Backdoor Roth from my employer’s 403b plan? It would seem that since IRS treats IRAs and 401k/403bs differently, I would not need to worry about the pro-rata rule applying to the balance in my SEP IRA when doing the conversion from my 403b plan. Am I correct?
Yes, you need to have the funds out of the SEP IRA as well.
My employer allows after-tax 401K contributions up to a max of 20% per paycheck. A few months ago they started allowing in-service conversions of after-tax to Roth 401K. I’ve been taking advantage of this new in-service conversion benefit every pay period (as we have no limit on how often we do conversions).
On the day my after-tax contribution gets deposited into my 401K, I immediately call Fidelity and arrange for a conversion of those monies to Roth 401K. The conversion happens the next day. This way I avoid gains on those after-tax monies and get no or a negligible tax hit from the conversion. So far this year I’ve converted about $33K to 401K Roth using this method, and that was on top of making my yearly $6,500 Roth IRA contribution. I’ve been a 401K savings machine the last few years, maxing out every retirement and tax advantaged bucket I can. I expect to retire within a couple months. 🙂
401(k) plans, as well as 403(b) plans are subject to certain nondiscrimination testing to ensure HCEs (highly-compensated employees) don’t benefit disproportionately to NHCEs (non-highly-compensated employees). One of those tests is called the Actual Contribution Percentage (ACP) test. Without getting into the nuts and bolts of the test (more information here https://www.irs.gov/retirement-plans/401k-plan-fix-it-guide-the-plan-failed-the-401k-adp-and-acp-nondiscrimination-tests), generally speaking, it includes Employer Matching Contributions AND Employee After-Tax Contributions (if a plan allows for them). Since discussions of Mega Backdoor Roth conversions (i.e., a rollover from a 401(k) of the Employee After-Tax source to a Roth IRA for the basis, while rolling the earning to a traditional IRA) are targeted to HCEs, and normally not of much interest to most NHCEs, we have a problem. Namely, the demographics and contributions patterns in most 401(k) plans will result in the ACP test being failed in a major way if the HCEs are plowing large amounts of Employee After-Tax Contributions into the plan, while NHCEs are either making no Employee After-Tax Contributions (or doing so in very small amounts). An employer will usually correct a failed ACP test by forfeiting any associated Employer Matching Contributions and returning any associated Employee After-Tax Contributions as Excess Contributions. Excess Contributions are not eligible for rollover. The bottom line is that unless your plan can pass the ACP test, much of the Employee After-Tax Contributions will simply be returned to the employee (assuming HCE).
Can you withdraw the employer contribution and then conduct a normal roth conversion? That amount would be counted as income, but it may be beneficial if you are in a low income year–and don’t have your own money.
What do you mean withdraw the employer contribution and then conduct the conversion? Are you doing a straight withdrawal and a conversion?
IS there a 5 year hold (similar to a rollover) on the contributions? Could I use the contributions (not gains), once they are in the Roth for an emergency?
Yes, each conversion has it’s own five year rule. This explains it: https://www.rothira.com/roth-ira-5-year-rule
Hello, thanks for the information.
I have questions for you.
I contributed $5,500 in 2016 for traditional IRA (Vanguard Total Stock Market Index Fund Investor Shares). Now, it becomes $7,270.24.
When I talked to one of the customer service specialist, he said I can transfer $7,270.24 into my Roth IRA. But, I have to pay tax for $7,270.24.
After that, I can withdraw, $5,500 without paying any penalty because $5,500 is the my contribution but not the earning.
If I want to take money beyond $5,500, for example, I take $7000, then I have to pay tax for $1500 because that is the earning from my investment.
Is all this information correct?
Thanks
No, to withdraw the principal ($5,500) penalty free, you must wait 5 years. There is a 5 year rule for Roth conversions that applies. Read this: https://www.kitces.com/blog/understanding-the-two-5-year-rules-for-roth-ira-contributions-and-conversions/
Thanks for your kindly reply and link.
I am planning to take money out of my traditional IRA and traditional 401K account in order to purchase house.
After reading the link you attached, I make two plans.
First, I will transfer my traditional IRA into Roth IRA in the year of 2018. I will pay tax from Roth IRA conversion in the year of 2019.
Second, I will transfer my traditional 401K into traditional IRA, and into Roth IRA in the year of 2018. I will pay tax from Roth IRA conversion in the year of 2019.
Then I will take money, including contribution and earning in the year of 2013 where I won’t have to pay any 10% penalty.
Would this sound possible? Am I missing boat?