Folks working towards early retirement, or just wanting to save more, sometimes feel limited by the contribution limits (pun intended!) that apply to retirement plans. But did you know that you can go beyond those limits? Enter the Mega Backdoor Roth.
To be clear, the Mega Backdoor Roth is not an extension of the “regular” backdoor Roth that allows you to sidestep the income limits for Roth IRA contributions (although there are many parallels). A Mega Backdoor Roth is for those with a qualified workplace retirement plan, such as a 401(k) or a 403(b). (I will refer to just “401(k)” plans for simplicity.)
Most 457(b) plans, which are offered by state and local governments, and the Thrift Savings Plan for federal government employees, have the same contribution limits as 401(k) and 403(p) plans.
What are the requirements?
If you are enrolled in a 401(k) plan and wish to contribute more than the annual limit ($22,500 for 2023), ask your plan administrator if you are allowed to make after-tax contributions beyond the annual limit. If the answer is no, then stop reading. If the answer is yes, then you have some decisions to make.
Your 401(k) plan must allow for after-tax contributions beyond the annual limit for you to participate in a Mega Backdoor Roth. Plans are not required to allow this, but many do.
After-tax contributions are exactly that: you get no tax deduction for them now, but they give you a basis in the plan. In that sense they are just like nondeductible contributions to a traditional IRA.
The amount you can contribute via a Mega Backdoor Roth depends on your employer contributions. Federal law limits the total amount that can go into your 401(k) in any given year between salary deferrals (i.e., employee contributions) and employer contributions. In 2023, that limit is $66,000. If you contribute the maximum salary deferral amount of $22,500—whether as traditional, Roth, or some combination of the two—and your employer contributes another $15,000, then you can make after-tax contributions of up to $28,500:
$22,500 + $15,000 + $28,500 = $66,000
Maximum Salary Deferral + Employer Contributions + After-Tax Contributions = Up to $66,000
You do not get a tax deduction for your $28,500 in after-tax contributions, but now you have an additional $28,500 basis in your 401(k). You can also choose to make smaller after-tax contributions: As long as the total contributions to the 401(k) do not exceed $66,000, the precise amount of after-tax contributions is up to you.
I made the extra contributions. Now what?
The same thinking that applies to a “regular” backdoor Roth applies to the “Mega” path as well: you do not want to simply leave the funds in a traditional account with their basis. Separate them into a Roth account right away to give you more options.
The path of least resistance is to add the extra contributions—$28,500 in the above example—to your Roth 401(k) balance, if your employer offers a Roth option within the plan, to separate your after-tax contributions from your pre-tax contributions. (Employer contributions are also generally pre-tax.)
Next, ask your plan administrator if you are allowed to make in-service withdrawals or transfers for non-hardship reasons. Hopefully the answer is yes. If so, move your “extra” contributions to your existing Roth IRA in a direct trustee-to-trustee transfer. A trustee-to-trustee transfer is where you never touch the funds yourself, preventing unwanted taxation. Do this at least once a year so that the funds are available within your Roth IRA. This allows you to strategize how to access those funds if you want to retire and withdraw them prior to reaching age 59.5, such as through a Roth conversion ladder.
If you cannot make in-service withdrawals or transfers for non-hardship reasons, then you will have to leave all your contributions in your 401(k), and wait until you leave that employer to move your after-tax contributions to a Roth IRA. While that is less than ideal, you still get the advantages of sheltering the growth on those contributions from taxes until they are ultimately withdrawn, so it provides more tax advantages than simply contributing that extra money to a regular taxable brokerage account.
Some plans that forbid in-service withdrawals or transfers absent a financial hardship may still allow you to do so with respect to your after-tax contributions, so be sure to ask about that specifically.
What else should I know?
The $22,500 employee contribution limit, and the $66,000 employee-employer combined contribution limit, is a per-person limit, not a per-employer limit, within a calendar year. If you have multiple employers offering 401(k)s, you cannot add the maximum to a 401(k) plan with Employer A and the maximum again to a 401(k) plan with Employer B.
Further, employees who will reach age 50 by the end of the calendar year may contribute an additional $7,500 to their 401(k) plan. If you can make catch-up contributions, a total of $73,500 may be added to your account during the year.
Finally, for those of you who are self-employed, this still applies to you! Remember that you wear both the employee and the employer hats. Be sure that your workplace plan allows you and your employees to utilize a Mega Backdoor Roth.
Is it worth the hassle?
A Roth IRA is a versatile account that gives you flexibility both in retirement and in death when you pass any remaining funds to your heirs. If you plan to retire early, contributing more money to a Roth IRA also provides you more funds that you can access in early retirement. Any steps you can take to get more money into a Roth IRA will help you in the long run, regardless of your retirement plans!
Ask your plan administrator today whether you can make after-tax contributions beyond the maximum salary deferral amount. The worst they can do is say no. Even if you are not in a position to actually make those extra contributions now, it never hurts to get started on making future plans.
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