“Should I consider contributing to a Roth IRA or Roth 401(k)?”
In recent years, this has become a popular question, as interest in building a tax-free bucket of money has increased. You can make annual contributions to a Roth IRA, but contributions are capped at $6,000 per year ($7,000 if you are 50 or older). Income limits restrict who can make direct contributions to a Roth IRA. Individuals who exceed these income limits may consider a Roth 401(k) or completing a backdoor Roth since there are no income limits associated with these options. There is also a lesser-known strategy you can use to direct significant amounts to a Roth IRA, referred to as a mega backdoor Roth.
What is a mega backdoor Roth?
A mega backdoor Roth is when an individual makes an after-tax contribution above the annual 401(k) contribution limits to their 401(k) plan. In 2021, the maximum amount that can be contributed to a 401(k) is $58,000, or $64,500 if you are 50 or older. The IRS determines the amount contributed by combining employee and employer contributions.
To determine how much you can add to the after-tax portion of the plan, take the maximum contribution amount mentioned above and subtract employee and employer matching contributions. The remaining amount is what could be contributed after-tax to the 401(k) and used for the mega backdoor Roth.
What is needed to complete a mega backdoor Roth?
A mega backdoor Roth is complicated and will only work under specific circumstances. Below is a list of three things required before completing this strategy:
- You have money left over to save.
- Consideration for this strategy only begins once you have maximized 401(k) and Roth IRA contributions. Then you can assess other opportunities: building a rainy-day fund, paying down debt, college savings, or contributions to a Health Savings Account, to name a few. A mega backdoor Roth IRA is a phenomenal way to get large amounts of money into the tax-free bucket but will only work for those who can set aside a lot for retirement savings.
- Your 401(k) plan permits after-tax contributions.
- After-tax contributions to a 401(k) are considered separate from your traditional and Roth 401(k) contributions. If your plan does not allow for after-tax contributions, then the mega backdoor Roth strategy is not an option. You will need to confirm with your employer or review your plan description to determine if after-tax contributions are permitted.
- Your 401(k) plan allows for in-service withdrawals or rollovers.
- An in-service withdrawal allows employees who are still working to distribute after-tax contributions from their 401(k) to a Roth IRA outside of the plan.
- A rollover allows employees to transfer funds from their after-tax portion of the 401(k) into the Roth 401(k) bucket. With this type of transaction all money will remain inside the 401(k) plan.
- This works best when individuals transfer after-tax contributions as quickly as possible into the Roth. Timely in-service withdrawals or rollovers will result in the most tax-free growth.
A mega backdoor Roth is a great option to quickly build a tax-free bucket of money for individuals who have maxed out other retirement savings vehicles, still have surplus to be invested, and have a 401(k) plan that allows for this strategy. Consider this an additional tool in your toolbox. Completing a mega backdoor Roth is complex so before making any decisions you should consult with your tax professional and a financial advisor. What does it mean to be Truly Cared ForTM? It means we understand your passions and use proven methods to help you reach your goals.
