Every time I think I have maximized my retirement savings in a given year, I discover a new way to push it even further. This time, it’s the after-tax to Roth conversion, aka the “mega backdoor” Roth conversion. And quite frankly, I’m frustrated with myself for not taking advantage of it sooner.
My annual retirement savings progression, over the years, has looked like this:
- Taking advantage of my employer’s generous 50% 401K match on the max 401K contribution permitted by the IRS (with Mrs. 20SF later doing the same).
- Contributing 25% of income from money earned through side hustles (including this site) to an SEP IRA.
- Switching from a PPO to a high deductible health plan (HDHP) paired with a health savings accounts (HSA), and making the maximum HSA contribution each year. HSA funds can later be withdrawn for non-medical expenses, similar to an IRA (if needed).
- Discovering that Mrs. 20SF’s 457B Plan effectively allowed her to double her pre-tax 401K contributions.
- And finally (I think), it’s taking advantage of the mega backdoor Roth conversion.
What is a Backdoor Roth IRA?
Before we get into what a mega backdoor Roth conversion is, let’s first cover what a backdoor Roth IRA is. In short, the backdoor Roth IRA gives high income earners, specifically those who are above the Roth IRA income limits, an indirect opportunity to contribute to a Roth IRA. In order to reap the benefits of a Roth IRA, they must take advantage of an IRS loophole and contribute through a non-deductible Traditional-to-Roth conversion, by doing the following:
- Contributor has both a Traditional IRA and Roth IRA with the same broker.
- Contributor reaches an income level that is over the Roth IRA contribution income limit in a given year.
- Contributor makes a contribution to a Traditional IRA for that tax year (up to the maximum IRA contribution of $6,000 in 2021; $7,000 if age 50 or older).
- After the contribution posts to the account (typically as soon as next day or after), contributor converts 100% of the funds from the Traditional IRA to a Roth IRA.
- Contributor does not claim a deduction for the IRA contribution when filing taxes.
There are a whole bunch of things to be aware of, so read up if you’re thinking about a backdoor Roth IRA conversion. In general, I prefer Traditional over Roth accounts, and especially think the backdoor Roth IRA conversion is a waste of a good tax deduction for high income earners. Mega backdoor Roth conversions, on the other hand, are a different animal.
What is a Mega Backdoor Roth Conversion (aka After Tax to Roth Conversion)?
In order to understand what an after-tax to Roth or mega backdoor Roth conversion is, you must first understand the three types of employer-sponsored retirement contributions you can make. Here’s a chart, to explain:
|Option:||Contributions:||Contributions when you Withdraw:||Earnings when you Withdraw:|
|Pre-Tax||Not taxed now||Taxable||Taxable|
Bolded emphasis on the difference on earnings at withdrawal between Roth and after-tax. You might see that and think,
Why would I want to make after-tax contributions if I’m taxed on contributions and on earnings at withdrawal?
That’s where the mega backdoor Roth conversion comes in.
If you convert after-tax contributions to a Roth account, the earnings on your converted funds now have the potential to be treated like other Roth IRA earnings – tax free at withdrawal. This assumes that you adhere to all of the standard Roth withdrawal rules, including the contribution being made more than five years prior and you are at least age 59.5, of course.
In effect, the mega backdoor Roth is taking your retirement contributions and turning it up to 11.
How Much can you Convert with a Mega Backdoor Conversion?
The maximum employer + employee 401K plan contribution in 2021 is $58,000, or $64,500 if you’re age 50+ with the “catch-up” contribution.
To calculate the maximum in after-tax contributions that you can make, subtract your 401K contributions and your employer’s matching contributions from that maximum.
For example, if under age 50, and your employer matched 50% of your contributions, the maximum in after-tax contributions you could make for 2021 would be:
$58,000 – $19,500 – $9,750 = $28,750
If no 50% match, the math would look like this:
$58,000 – $19,500 = $38,500
The Benefits of a Mega Backdoor Roth
When executed effectively, a mega backdoor Roth conversion will have the following benefits:
- You will have boosted your retirement savings to a higher level than typically allowed under the standard 401K and Roth IRA contribution limit rules.
- You will have not prevented your ability to also make pre-tax contributions to your Traditional IRA.
- You will have avoided income restrictions typically associated with contributing to a Roth IRA (401Ks and conversions from them do not have income restrictions).
A mega backdoor Roth conversion is very different than the standard backdoor Roth IRA conversion. If you choose to contribute to a Roth IRA or to complete a backdoor Roth IRA conversion, you are choosing to be taxed now instead of later. Missing out on the tax deduction is a downside. The mega backdoor conversion is a different choice. Since you are going to pay taxes on the income anyways – your choice is simply “do I want to have tax-free earnings (via the conversion)?” or not. That’s a much easier choice. And if you need to access contributed funds later, you can withdraw them, without being taxed, at any time.
Mega Backdoor Roth IRA Conversion Caveats
I am a big fan of the mega backdoor Roth conversion for the reasons stated – if you have the income and cash flow to pull it off – which is no easy feat. That being said, there are some notable mega backdoor Roth conversion caveats to be aware of:
- Not all 401K plans allow after-tax contributions or after-tax to Roth conversions.
- Always get the maximum 401K match from your employer by making the maximum Traditional or Roth 401K contributions before making after-tax contributions.
- Since you are likely in a higher tax bracket, it might make more sense to prioritize HSA contributions (which are tax deductible) first, if you can.
- Check with your employer on the fine print around fees to help decide if an in-plan Roth 401K conversion or Roth IRA conversion makes more sense (and if even possible). You may be able to convert the after-tax contributions manually or automatically with an in-plan conversion to a Roth 401K, or manually into a Roth IRA.
- This article should not be construed as a recommendation. It’s always best to run the numbers by a professional, when in doubt.