Mega Backdoor Roth: All About Its Working

A mega backdoor Because a Roth IRA is financed by after-tax 401(k) contributions; the conversion is not subject to federal income tax. The most mega backdoor Roth IRA contribution in 2022 will be $40,500, an increase from $38,500 in 2021.

What Is a Mega Backdoor Roth?

To better understand the mega backdoor Roth, let’s first go through the fundamentals of standard and Roth IRAs. Investors may contribute up to $6,000 in pre-tax money to a conventional IRA, which permits the money to grow tax-free over time.

Unlike traditional retirement accounts, which have a contribution limit of $6,000, Roth IRAs allow participants to fill their accounts using after-tax funds.

Because there are income limitations for investing in a Roth IRA, not everyone can participate. On the other hand, anybody may convert traditional IRA contributions into Roth IRA contributions, regardless of whether or not they satisfy the Roth IRA income requirements.

Because it permits persons who would not otherwise be qualified for a Roth to benefit from tax-deductible contributions, this kind of conversion is referred to as a backdoor Roth conversion.

The mega backdoor Roth functions the same way as the backdoor Roth, except that investors finance it with non-deductible (after-tax) contributions to a standard 401(k) plan instead of pre-tax contributions.

Traditional 401(k) contributions worth up to $40,500 after-tax may be converted into Roth IRA contributions in 2022. The after-tax contributions made to the 401(k) are used (k).

Mega Backdoor Roth IRA

The mega backdoor Roth IRAs are a terrific approach for increasing your money’s growth while keeping it tax-free, but there are some restrictions. It is required that investors make after-tax payments to one of the two types of qualified retirement plans: 401(k) and 403(b). 

The plan administrator must be contacted to determine whether or not this is an option for the investor’s particular plan.

Once investors have made their after-tax contributions, they will wish to take advantage of the opportunity to make an instant in-service withdrawal. While most plans permit withdrawals while still in service, this is not always the case.

Investors should consult with their plan administrator for further information on the procedure. Investors prefer to withdraw their funds as soon as possible after contributing because they do not want their donations to increase and become subject to taxation.

The Internal Revenue Service must disburse after-tax payments with the recipients’ earned income when the money is withdrawn. Investors are not permitted to withdraw their after-tax contributions from their accounts.

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Mega Backdoor Roth 401(k)

The mega backdoor Roth 401(k) functions similarly to the Roth IRA in taxation. However, with the employer’s plan, the member may form a Roth 401(k) for tax purposes (k).

It enables after-tax payments to be made directly to a 401(k) plan rather than an intermediary. The advantage is that it avoids the requirement to distribute monies equitably. Contributions made by participants may be used directly to the conversion.

Mega Backdoor Roth 403(b)

In the same way that a Roth 401(k) conversion works, a mega backdoor Roth 403(b) conversion works as well. It is possible to immediately convert the after-tax contributions to the 403(b) plan into a Roth 403(b) plan.

Investors may discover that 403(b) plans do not always permit them to contribute to the plan after tax. Regarding the regulations, investors should consult with their retirement plan administrator.

How a Mega Backdoor Roth Plan Works

The mega backdoor Roth method is effective because: 

  • Taxes have already been paid: After-tax monies are used to finance the account by investors.
  • Growth is exempt from taxation: Making the funds tax-free, rather than tax-deferred, allows the money to grow more quickly than it would otherwise.
  • Enables additional contributions to be made: The maximum mega Backdoor Roth conversion in 2022 is $40,500 (plus applicable taxes).
  • Takes use of a tax loophole to generate income: The Roth allows investors who would not otherwise be eligible to contribute to a Roth to benefit from the tax-free growth of the Roth.

Mega Backdoor Roth Tax Reporting

It is necessary for investors to correctly disclose the mega backdoor Roth IRA conversion to benefit from the tax advantages. It is important to note that this conversion has two forms to watch for a while: Form 1099-R and Form 5498.

The Form 1099-R will inform investors of the amount of money that has been taken out of a retirement account. Investors may choose a payout subject to taxation using just the form if the funds are not redirected to another qualifying plan.

Form 5498 is issued to the IRS when investors convert their money and fund their Roth IRAs. It keeps track of the amount of money that has been deposited into the Roth IRA. The 1099-R and Form 5498 should be identical to prevent any taxable events.

Advantages of a Mega Roth

The following are the advantages of a mega Roth IRA:

  • There are no tax implications: Investors have already paid their taxes because it is supported using after-tax funds.
  • Allows for contributions to a Roth IRA of up to $6,000 per year in addition to the current limit of $6,000 per year.
  • Roth becomes available to persons who would otherwise be ineligible: Roth IRAs are subject to rigorous income restrictions, which the backdoor Roth IRA circumvents.

Is The Mega Backdoor Roth Too Great To Be True?

Persons with high salaries utilize mega backdoor 401(k) rollover strategies such as Roth to transfer cash from their 401(k)s to Roth individual retirement accounts (IRA).

This little-known method is only effective in very certain situations, such as when a person has a substantial amount of excess money that they would want to put into a Roth IRA. If that describes you, here’s what you should know.

Roth Account Basics

Before we get into the specifics of the mega backdoor Roth, it’s important to understand how Roth retirement funds and backdoor Roth IRA conversion operate in general.

Roth Contribution Basics

The Roth 401(k) and the Roth IRA, Roth retirement plans allow you to make contributions using money that the IRS has already taxed. These contributions grow tax-free, and you won’t owe any income tax on qualifying withdrawals in the future if you continue to make contributions.

Contributions to a Roth 401(k) plan are permitted regardless of your yearly income if your company provides this option. However, not everyone qualifies to make contributions to a Roth IRA.

Backdoor Roth IRA Basics

If your income exceeds the limits set out above, you will not make direct grants to a Roth IRA. A backdoor Roth IRA conversion, on the other hand, allows high-earners to transfer assets from a standard 401(k) or traditional IRA into a Roth IRA without having to leave their current job.

To make a complicated procedure a little easier to understand, you’ll want to put your money into a standard IRA first. Direct contributions to regular IRAs and rollovers of money from traditional 401(k) accounts are also options for accomplishing this goal in retirement.

This is followed by converting the regular IRA to a Roth IRA. It nearly usually entails paying income taxes on any monies transferred into a Roth account that has not already been taxed, which is why you’ll want to do this as quickly as possible after depositing cash into a regular account to reduce the possibility of making a profit.

There are no limits on who may convert their IRA to a Roth IRA based on their income. Contributions to a conventional IRA must be made following the IRS annual contribution limitations in effect during the calendar year in which they are made.

You may, however, get around these restrictions by transferring money from your employer’s retirement plans, which have far greater contribution limitations.

How Does a Mega Backdoor Roth Work?

A mega backdoor Roth allows you to transfer up to $45,000 from a standard 401(k) to a Roth IRA without having to pay any of the taxes that would otherwise be due on such a conversion.

It’s important to note that adopting this plan only makes sense if you’ve already reached your yearly 401(k) and IRA contribution limits and still have a sizable amount of cash that you’d want to put into a Roth IRA.

As a further requirement, you must be enrolled in an employer-sponsored conventional 401(k) plan that allows for after-tax contributions and withdrawals while still employed.

After-tax contributions

After you have exhausted your annual 401(k) contribution limit, some plans enable you to make extra after-tax contributions until you reach your maximum contribution limit for the year.

As the name implies, these donations consist of money already being subjected to taxation. Roth contributions are comparable to after-tax contributions, except that profits on after-tax contributions are subject to income tax upon withdrawal. 

At the same time, Roth earnings are not subject to income tax. What are the benefits of making after-tax contributions? They may still be able to assist you in avoiding capital gains taxes.

In-service withdrawals

When it comes to retirement funds, most, but not all, allow members to take withdrawals from their accounts while they are still working.

The mega backdoor Roth procedure requires that you make after-tax contributions and then promptly remove them from the account to avoid having the contributions create returns that would be taxed during a rollover.

If your plan does not allow for in-service withdrawals, you can still conduct a huge backdoor Roth after you leave your present employer, but you will very certainly owe taxes on any investment returns you get as a result of the transfer.

If you’re self-employed and participate in a solo 401(k), you may be one step ahead of the curve. Not all large solo 401(k) providers enable after-tax contributions and in-service withdrawals by default, especially for smaller providers.

Nonetheless, if yours does not, you may be able to modify your plan quite simply and cheaply to accommodate these requirements.

401(k) Contribution Limits Are Important to the Mega Backdoor Roth

Take note: You will be unable to make the after-tax contributions necessary for a gigantic backdoor Roth until you have met your 401(k) employee contribution maximum. That’s $19,500 in 2021, or $26,000 if you’re above the age of fifty-one.

However, it is not the sole limitation on 401(k) contributions. A matching contribution from your company is also available: It may contribute up to enough to raise your total contribution to $58,000, or $64,500 if you are 50 years or older.

If your firm isn’t contributing the maximum amount allowed under the agreement, you may be able to make up the shortfall via your after-tax payments.

In the absence of employer contributions, the maximum amount you may contribute in this manner in 2021 is $39,500 (or $45,000 for persons 50 and over). However, there is a good probability that your company will contribute to your future.

The following is an example of how Roth math might be used as a mega backdoor: Consider the case of someone who is under the age of 50 and has made the maximum yearly conventional 401(k) contribution. This individual’s company makes a regular 6 percent matching payment toward their education.

  • Individual contribution of $19,500 plus employer match of $1,170 equals $20,670
  • A total of $58,000 in 401(k) contributions is allowed – $20,670 in regular contributions.

 $37,330 available for after-tax contributions

You’ll want to contribute up to your after-tax contribution limit to your standard 401(k) and then transfer that amount to a Roth IRA at the brokerage of your choice after you’ve reached that amount.

Any regular pre-tax contributions should be left in your 401(k) plan unless you intend to pay taxes on the money you get in return for converting them.

Meet the Rollover Before Earnings Accrue

As soon as possible, you should convert your funds to avoid the possibility that your funds may earn any investment returns, which would result in a tax bill when the funds are converted.

Assume that your after-tax contributions do result in increased investment growth. According to the IRS guidelines, the Internal Revenue Service permits you to divide the assets, rolling the after-tax contributions into a Roth IRA and the investment profits into a regular IRA.

Mega Backdoor Roth and the Pro-Rata Rule

Withdrawals from 401(k) plans are normally subject to the pro-rata rule. According to this regulation, you are not permitted to withdraw pre- or post-tax contributions from your typical 401(k) (k). You must withdraw an amount proportional to the ratio of your contribution sources to your total contributions.

In the example above, if you had a typical 401(k) account balance of $100,000, and $80,000 of that balance came from pre-tax contributions, and $20,000 came from after-tax contributions, each of your withdrawals would take out $8 in pre-tax money for every $2 in after-tax money from your account.

The pro-rata rule applies to the mega backdoor Roth, which means you can’t make an in-service withdrawal of just post-tax contributions if your regular 401(k) balance contains a mix of pre-and post-tax money.

As an alternative, you may be required to do a massive backdoor Roth conversion of your entire 401(k) amount. When faced with a circumstance like this, it’s better to roll your pre-tax contributions into a typical individual retirement account.

The fact that your employer maintains pre-tax and post-tax contribution amounts—and the growth of those amounts—may allow you to get around this and take the whole of your post-tax payments altogether.

Here’s another complication.

It is possible to wind up with pre-tax contributions in your conventional 401(k) even if your traditional 401(k) balance is $0 at the beginning of the calendar year and you only contribute to a Roth 401(k) before reaching your post-tax contribution threshold (k).

This is because any 401(k) matching payments made by an employer must be deposited in non-Roth accounts. It implies that if you attempt to convert the full of your balance, you may be subject to taxation; instead, you may transfer your employer contributions to a regular IRA.

Who Should Regard a Mega Backdoor Roth?

Before you get too excited about the prospect of being able to contribute more than the standard $6,000-$7,000 per year Roth IRA contribution restrictions, it’s crucial to recognize that a mega backdoor Roth plan is only suitable for specific individuals, as explained below.

Brent Weiss, CFP, co-founder of Facet Wealth, describes the situations in which a massive backdoor Roth could be appropriate for you:

  • You have already reached the maximum amount of contributions to your standard 401(k).
  • You cannot make direct Roth IRA grants because your earnings are too high to qualify.
  • You would want to make a contribution that exceeds the yearly IRA contribution restrictions.
  • Likely, you’ve already taken care of other important financial objectives, such as debt repayment, education savings, or saving for shorter-term aims.
  • The amount of excess income or money you have to donate after taxes is adequate for you to do so.
  • Both after-tax and in-service withdrawals to a Roth IRA or transfers to the Roth 401(k) component of your company’s 401(k) plan are permitted under your company’s 401(k).
  • “When deciding to give after-tax cash, it’s critical to consider how it will impact other aspects of your financial life,” adds Weiss.

Why Do Some Businesses Not Permit the Mega Backdoor Roth?

Even if you have the additional funds and a 401(k) plan that has the essential elements to enable you to execute the mega backdoor Roth rollover, Weiss is quick to warn out that some employers do not accept after-tax 401(k) contributions, which may be frustrating.

According to the author, many 401(k) plans would fail non-discrimination criteria if after-tax contributions were allowed.

The Internal Revenue Service restricts the amount of money that highly paid workers may contribute to some retirement plans compared to the amount of money that other employees in the same plan who are not highly paid can contribute.

As Weiss points out, “since non-highly paid workers often cannot save more than the standard 401(k) limitations, most plans would fail the non-discrimination requirements if they permitted after-tax contributions.”

Options to a Mega Backdoor Roth

If you are resolved to save more funds for retirement, there are a few alternatives to a mega backdoor Roth IRA.

Fund in a taxable account

“If the aim is to leave money to the future generation, buying and holding common stocks that do not pay dividends may be an excellent way to achieve the same purpose,” says Paul Axberg, CPA, CFP, and president of Axberg Wealth Management.

“This works because the stocks increase tax-deferred, and when the owner dies, the heirs get a stepped-up basis equal to the value of the stock at the time of the death, which is beneficial.

All capital gains are no longer subject to taxation as a result of this.” If your stocks do provide dividends, you will be required to pay income taxes on those payments every year, but the rate may be lower than your other sources of income.

Create a common backdoor Roth IRA conversion.

You should stay with the common backdoor Roth IRA conversion if your retirement plan does not include the components required for a massive backdoor Roth IRA conversion. Even if your income is too high to qualify for a Roth IRA, you may make non-deductible contributions to a conventional IRA, which you can then convert to a Roth IRA later.

To avoid triggering a taxable event, Weiss recommends that you “make sure you don’t have any additional pre-tax monies in any sort of IRA, such as SEP or SIMPLE IRAs,” since this would result in a taxable event.

Contribute to a Roth 401(k)

While this option does not allow you to make large, additional contributions, it does allow you to take advantage of tax-free withdrawals by contributing the maximum amount allowed by law to a Roth 401(k) (k).

Final Words

Consider the following scenario: you have enough income and a 401(k) plan to make a mega backdoor Roth feasible. That puts you in a good position to put money aside for retirement while also benefiting from the tax-free advantages of a Roth IRA and the freedom from having to take required minimum distributions from your retirement account (RMDs).

And if the mega backdoor Roth isn’t a good match for your financial circumstances or income, don’t worry; there are other possibilities.

In the case of any difficult retirement strategy, consulting with a tax specialist or a financial counselor is recommended before embarking on a massive backdoor Roth conversion.

If you choose this strategy without first thoroughly understanding all of the moving parts, you may find yourself with what Axberg refers to as a “mega front-door tax bill.” If you choose this strategy without first thoroughly understanding all of the moving parts, you may find yourself with what Axberg refers to as a “mega front-door tax bill.”

The mega backdoor Investments in Roth accounts enable investors to store huge sums of money in a tax-deferred account that grows in value tax-free. Investors must pay close attention to the requirements to avoid unintentionally triggering a taxable event.

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