The Mega Backdoor Roth IRA Strategy [Video]

Today we’re going to be talking about the Mega Backdoor Roth IRA strategy.

This is one of the most important strategies that we as financial advisors have available to us. This allows us to help high income earners save a lot more for retirement. Now this particular strategy is different from the regular Backdoor Roth IRA strategy which maybe you have heard about. We have a separate video on that, so if you want to learn more about that, click here! 

The Mega Backdoor Roth strategy really resides within your 401(k) plan with your employer.  This is all done within your employer’s 401(k) plan. Now, unfortunately, not all 401(k) plans allow this strategy.

What Should You Look For? 

The first thing is you have to see if you are able to make after tax contributions to your 401(k). This is after you’ve maxed out your 401(k) with your normal salary deferrals. You also need to see if you are able to make after tax contributions with that money. This strategy only works if you are able to do that. That is really one of the most important pieces. 

The second thing that your plan has to have to allow for this strategy is one of these two things.

1. Either you have an in plan Roth conversion, where they actually let you do the Mega Backdoor Roth right in the plan.
2. Or you have a plan that allows you to do this but in a less straightforward way, which might be called an in service distribution.

You would roll out part of your 401(k) each year into a Roth IRA. Now like I said, every plan is different so you really need to do your homework. Maybe you need to ask your HR or financial advisor if this is available for you. 

If it is, let’s go ahead and jump into how you do a Mega Backdoor Roth IRA Conversion.

Mega Backdoor Roth IRA Limits 

A lot of high income families that we work with do a great job maxing out their 401(k)s for retirement. But the problem is if you are a high income earner, even that might leave you short of what you need in retirement to sustain your lifestyle. That’s really where the Mega Backdoor Roth strategy comes in. 

It allows you to save a lot more money into your 401(k) than you would be able to normally. But in order for you to do this, you first need to understand how the contribution limit works for 401(k)s. I am going to be using 2022 numbers, but all you need to do is google “401(k) limits for this year” to find what you need. There are three pieces that go into your 401(k) limits.

The first and most common is what is called salary deferral. In 2022, you can put up to $20,500 into your 401(k). If you are age 50 or over, you can put in another 6,500 above and beyond that. This is the most common limit that people think of when they hear about 401(k) contribution limits. 

What a lot of people don’t realize is there is actually a much larger limit for how much money can go into your 401(k) each year. That limit for 2022 is actually $61,000 and that is partially made up of salary deferrals. Let’s say you maxed out the $21,500 limit for salary deferrals. Employer matches really depend on your company. But let’s assume that they will match $5,500 and then that leaves the after tax contributions. If we take $61,000 minus what you have put in for salary deferrals minus the employer match, that leaves another $35,000 in after tax contributions that you can put in. You can see how this is a really really powerful savings tool. 

Now if you think about Roth IRAs, you are limited to only put in $6,000 or $7,000 a year. But with the Mega Backdoor Roth strategy, the amount that you can get into that Roth completely depends on how much your after tax contributions could be. In this example that I did, this person would be able to put in $35,000 of after tax contributions. Compare that to what you are able to do with a Roth IRA. This is why this strategy is so powerful for high income earners.

How to do the Mega Backdoor Roth IRA

Unfortunately, this strategy is going to cause a little math work but once we see how to do it, you will be able to figure it out easily. Let’s use the example from before so we can focus on the key pieces of information that we need. Again, we are using limits for 2022 so the total amount that could go into your 401(k) in 2022 is $61,000. That is where we start. 

Then what we do is subtract how much our salary deferral is. If we are maxing out 401(k) limits and are under the age of 50, that would be $20,500. If you are age 50 or over, you can put in another $6,500 for catch up contributions which would equal $27,000. But we will stick with the before age 50 number. The employer match is where a lot of people get hung up. Every company is different. Some will give you a set dollar amount that they will match, others say they will match X% of your salary  contributions up to X%. You can see it is really important to look into the details of how they match. If we use the example from before, we are going to say this company will match up to $5,500 for everyone’s 401(k) every year. 

Let’s do the math. If we go from starting at $61,000 minus $20,500 minus $5,500 employer match, that leaves us with a total of $35,000 total potential after tax contributions. 

These contributions represent how much you can get into a Roth. This is where a lot of wealth is built. The one thing you have to remember is that this is after tax. You have to be cognizant as you go through your monthly budget that every dollar you put into your 401(k) is a dollar less that you will have in your net paycheck. But a lot of companies are different and have different ways of allowing you to set your after tax contributions. For some, it looks very similar to salary deferrals. We’ve seen other cases where you are required to say a specific dollar amount. 

The last step of doing a Mega Backdoor Roth IRA is to get it converted into a Roth. As I mentioned at the outset, there are two ways companies allow you to do this. The first is an in plan conversion feature. This allows you to move money directly into the Roth 401(k) portion of your plan. This is the easiest way to roll the money over. 

If your company doesn’t have that feature, what they might allow you to do is an in-service distribution. The company is saying, we will allow you to take this money out of the 401k completely and just move it to your own Roth IRA. This is a little bit more complicated and you have to be careful when pulling money out of your 401k that you aren’t missing anything up from a tax viewpoint.  

Next Steps for the Mega Backdoor Roth IRA Strategy

The Mega Backdoor Roth IRA strategy is a great way to save more money. Now I realize going through this strategy is a bit of a mouthful. We have written a comprehensive post going into great detail about how the Mega Backdoor strategy works.

The key thing we want you to take away is not everyone can do this. You have to know if you can make after tax contributions or some sort of distribution to roll the money into a Roth. As a high income earner, it is extremely important that you’re utilizing every strategy that you can so you can save enough for retirement. If you want to talk with a financial advisor about all these details, reach out! We would be happy to help!