Secret Retirement Saving Super-Power: The Mega Back Door Roth

May 26, 2020

For high earners and big savers, there are limitations on contributions to designated retirement accounts. Specifically, in 401k accounts, the maximum you can deduct from your salary is $19,500 in 2020. For those over 50, a “catch-up” contribution is allowed up to an additional $6,500.

What many don’t know about 401k accounts is that there is actually a higher secondary limit that takes into account all contribution sources. It allows up to $57,000 or $63,500 after age 50 in 2020.

If you are 50 or older in 2020, you can contribute $26,000. The employer, assuming a 3% match on a $200,000 salary, would add $6,000. The total additions to your 401k would be $32,000. Still $31,500 less than allowed under the larger secondary limit. How can you optimize your 401k account to increase your retirement savings? Enter the Mega Back Door Roth strategy.

What is a Mega Back Door Roth?

You may be familiar with the more common Back Door Roth IRA contribution. For IRAs, high earners can get around the income limit on Roth contributions by adding non-deductible (after-tax) dollars to their Traditional IRA and then converting it to their Roth.  Investment gains are taxed as income on the transaction. If the conversion occurs prior to investing, gains can be avoided, or at least minimized. Essentially, it is a necessary extra step to achieve the same result because income levels eliminate the ability to make the contribution to a Roth IRA directly.

The Mega Back Door Roth works in a very similar fashion. After reaching the Traditional/Roth employee contribution limit in your 401k, you would continue making contributions ‘after-tax’. Only the earnings are treated as deferrals, meaning they are taxed when withdrawn in retirement. However, just like in the IRA strategy, by converting quickly or staying in cash to limit investment gains, the subsequent conversion can have minimal tax implications.

Done correctly, using the scenario laid out earlier, could be the equivalent of a $31,500 Roth contribution.

Equivalent to more than four annual regular Back Door Roth IRA contributions, but you can do it every year! That seems like a slam dunk, doesn’t it?

What’s the Catch?

Every 401k plan is like a classroom. The school has rules that everyone must follow. The teacher of each classroom decides what is, and is not, acceptable in their classroom – to a certain extent. The teacher is your 401k plan. While it must follow the rules of the school- the IRS- there are areas where choices can be made. Like high school, just because one teacher allows you to chew gum in class doesn’t mean it is acceptable to another.

The Mega Back Door Roth requires 401k plans to choose many non-standard options. After-Tax contributions, a separate accounting of funding sources, and some combination of in-plan conversions or in-service distributions (which would allow distribution to a Roth IRA), among others. The thing is, drafting the plan design, record keeping, and maintenance of all this is expensive – not to mention it is still a new strategy. Many companies do not want to incur the additional costs or burden their employees with the added expense.  Some others may simply not be aware of the opportunity yet. 401k plans tend to be slow to change.

Sound Like Your Kind of Deal?

More company retirement plans are coming on board, especially at larger businesses that can absorb the cost through scale. If you are interested in this idea or want to learn more, give your BDF Team a call to discuss your unique situation. They will help provide guidance if you are able to implement the Mega Back Door Roth strategy within your financial plan.

Josh Larson is a Senior Advisor at BDF and sits on the firm’s Financial Planning Committee, which is responsible for educating the BDF team on financial planning topics and improving the team’s processes to ensure each client benefits from proactive, best in class financial advice. He studied at Aurora University and earned degrees in Accounting and Business & Commerce. Josh is a CERTIFIED FINANCIAL PLANNER™ professional.