How Does the Mega Backdoor Roth Help You Save for Retirement?
Lars Phillips | February 5, 2021
The Mega Backdoor Roth 401(k) is an unbelievable provision becoming an increasingly popular employee benefit within 401(k)plans. This benefit is available at companies like Microsoft, Amazon, Facebook, Google, Salesforce, VMware, Boeing, Snapchat, and others. If you’re unsure whether your company offers this benefit – your HR department can let you know.
There are two eligibility requirements for the Mega Backdoor Roth 401(k). Your 401(k) plan must allow the following:
- After-tax contributions to your 401(k)
- In-plan Roth conversion
This new video explains how this benefit works and demonstrates how the Mega Backdoor Roth Conversion strategy can help you invest more towards retirement. The video will also illustrate the tax reduction benefits associated with this strategy over the long term.
The best thing about the Mega Backdoor Roth is it lets you invest thousands more every year towards your retirement!
In traditional 401(k) plans you are limited to how much you can save into your retirement account. In 2021, if you are under 50 years old the contribution limit for a 401(k) is $19,500. If you are over 50 the annual limits increase by $6,500 for a total of $26,000.
Let’s walk through an example of how the Mega Backdoor Roth works for someone under 50 years of age.
Most employers contribute some sort of match to an employee’s 401(k) plan. In this example, we assume your employer is adding an additional $5,500 to your 401(k).
- Your contribution: $19,500
- Employer match: $5,500
- Total contribution between you and your employer: $25,000.
With that said, there is a federal limit for total employer and employee contributions to 401(k). In 2021, the federal limit is $58,000 for individuals under 50, and $64,500 for those 50 and over. Let’s do a little more math:
Using our example above, the $58,000 federal limit less your $25,000 (employer and employee) 401(k) contribution, leaves a delta of $33,000 between what you and your employer originally contributed to the 401(k) and what the IRS allows.
Now we begin to see the benefit of the Mega Backdoor Roth Conversion
Companies that allow the Mega Backdoor Roth conversion will let you make an after-tax contribution into your 401(k). Every company is a little bit different, some will let you max out the entire difference (in this case $33,000), others allow you to put in a certain percentage of your salary, while others might put a cap on the total dollar amount you can contribute.
In this example, you are able to contribute $33,000 into the after-tax portion of the account. As soon as this contribution is made, you will want to convert those after-tax dollars to Roth as soon as you possibly can.
Pay attention to the Roth conversion rules in your plan! Some plans will do the conversion for you automatically, some are more manual.
Automatic Roth Conversions: For plans with this feature, you may see a dropdown on the contribution section within your 401(k) which allows you to state you want to convert these dollars as soon as possible.
Manual Roth Conversions: You might have to reach out to your 401(k) provider and ask them to convert these dollars for you and request they set up automatic conversions on a go-forward basis.
How does the Mega Backdoor Roth reduce taxes?
Many of you reading this are saving money above and beyond your 401(k) and more than likely you’re saving into a brokerage account (individual account, joint account, etc.). Within these accounts you hold investments, which inevitably over time kick off interest income, dividends, and capital gains. All of these events are taxable within brokerage accounts. Over the long-run, this taxation can create a substantial tax drag on performance.
Within a Roth you could hold the exact same investments, but the same interest income, dividends, and capital gains would all be tax-free now and when you retire!
Additionally, when you do retire, having additional money in a Roth account enables you to manage your retirement distributions and give you more control over your taxable income, which could allow you to save even more from a tax perspective.
Bottom line. If your company offers the Mega Backdoor Roth Conversion and you’re saving outside your 401(k) for the long term – it is a benefit you should take advantage of.
If you work for a company that allows the Mega Backdoor Roth Conversion, you might be able to contribute over four times as much to a Roth as someone who doesn’t have access to this feature within their 401(k)!
Needless to say, the long-term benefits of increasing your retirement savings, particularly by utilizing the Mega Backdoor Roth Conversion strategy, could make a massive positive impact on what your retirement looks like.