How Mega Backdoor Roth Contributions Work

An Attractive Strategy That’s Not Always Available

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If you like the idea of having money in a Roth IRA, you may appreciate a rare opportunity to contribute as much as possible to Roth accounts each year. With a mega backdoor Roth strategy, you can save a substantial amount, but your employer’s retirement plan needs to allow this strategy.

In this article, we review the basics of a mega backdoor Roth, and we discuss the requirements to use this strategy. You’ll understand how to save a substantial amount of potentially tax-free money and why the strategy may appeal to self-employed people.

Key Takeaways

  • A mega backdoor strategy allows you to save a substantial amount of money in Roth accounts.
  • Your employer’s plan needs to offer after-tax contributions, which are different from Roth deferral contributions.
  • In many employer plans, the strategy is not available because of testing pitfalls.
  • This approach can work well if you’re self-employed.

What Is a Mega Backdoor Roth Strategy?

When you use a mega backdoor Roth, you make after-tax contributions to your employer plan and transfer that money to a Roth account. For 2021, you can potentially save as much as $58,000 of Roth-type money through your employer’s plan—if your situation allows.

Mega backdoor Roth is different from making designated Roth 401(k) or Roth 403(b) contributions. Standard “designated Roth contributions” are allowed in many plans, but the annual limit on those salary-deferral contributions is $19,500 in 2021 (or $26,000 if you qualify for the catch-up contribution after age 50). 

But with mega backdoor contributions, you can save additional dollars that eventually go into a Roth account. To do so, your employer’s retirement plan needs to allow voluntary after-tax contributions. When that’s the case, you can contribute as much as you want (up to annual retirement plan limits) and move the funds to a Roth account.

Roth money can potentially provide tax-free income in retirement. If you satisfy all IRS rules, you can withdraw your contributions plus any earnings without needing to pay income tax on those withdrawals.

For example, for 2021, the overall 401(k) contribution limit is $58,000 for those under age 50. So, after contributing $19,500 of salary deferral to a Roth 401(k), that leaves another $38,500 available. Assuming your employer does not make any matching or profit-sharing contributions for this simplified example, you’d be able to contribute an additional $38,500 if you have the funds available—and if your plan allows.

How To Make Mega Backdoor Roth Contributions

Verify Availability

To make mega backdoor Roth contributions, you need an employer-sponsored retirement plan that allows after-tax contributions. For example, your job’s 401(k) or 403(b) might offer that option. 

Not all plans allow after-tax contributions, and your employer must choose to enable this option.

If your employer does not allow after-tax contributions and you can’t contribute to a Roth IRA, consider (smaller) backdoor Roth IRA contributions.

Make After-Tax Contributions

After-tax contributions are different from designated Roth contributions. It’s easy to confuse the two because Roth contributions are, in a way, also after-tax contributions. But for a mega backdoor contribution, you make additional after-tax contributions after maxing out your 401(k) salary deferral contribution.

To make after-tax contributions, notify your employer that you’d like to do so. The payroll provider will deduct those funds from your earnings and send that money to your retirement plan.

Transfer to a Roth Account

Once you have money in an after-tax account, you move the money to a Roth account. By doing so, any future growth can potentially come out tax-free in retirement. There are two ways to complete the transfer:

  1. Make the change within your retirement plan if in-plan conversions are allowed.
  2. Roll the after-tax money to a Roth IRA if your plan allows that type of in-service distribution.

Ask your employer how to complete an in-plan conversion or a rollover to your Roth IRA. It may be best to move funds from your after-tax account to a Roth account as quickly as possible after making contributions. That’s because any earnings in your after-tax account may be taxable when you make the conversion, and moving quickly can minimize those earnings.

Why Your Employer Might Not Allow the Strategy

If your employer allows you to make mega backdoor Roth contributions, you’re fortunate. Some employers don’t know about the strategy, or they are unwilling to enable after-tax contributions because of regulations that govern retirement plans.

Retirement plans need to follow complicated rules. Depending on the demographics at your workplace, those rules may make it difficult to include voluntary after-tax contributions to your plan.

The IRS offers tax benefits to employers and employees that use retirement plans. But workplace retirement plans are required to benefit all employees—not just business owners and highly compensated employees. To evaluate a plan’s fairness, retirement plans undergo nondiscrimination testing each year, and voluntary after-tax contributions can cause many plans to fail those tests. When that’s the case, it doesn’t make sense for employers to offer a mega backdoor strategy.

Self-Employed Individuals

If you’re self-employed with an individual 401(k), you may be an excellent candidate for this strategy. You have no other employees to cause testing problems, so you can typically set up a mega backdoor Roth. However, you typically can’t use the strategy with off-the-shelf individual 401(k) plans. Instead, you’ll most likely need to use a service provider like a third-party administrator (TPA). That company can provide a plan document that accommodates the strategy, and those services help with conversions and reporting. There are several providers that will work with you online, or you can search for local pension consultants and TPAs.