Summary/TL;DR
A mega-backdoor Roth conversion is nothing more than the implementation of the backdoor Roth strategy within an employer retirement account such as a 401(k) or 403(b). And due to the significantly higher contribution limits within an employer retirement account relative to an IRA and the fact that there are no income phaseouts for higher income earners within these plans, the mega-backdoor Roth strategy is one of the most powerful tax and retirement planning tools in a high-income earners belt. The facilitation of these transactions should never take place without the assistance of a competent professional, as there are many nuances that can lead to big mistakes.
Introduction
Many high-income earners find themselves making too much to contribute to a Roth IRA, meaning any Roth contributions will have to be made through their employer’s retirement plan. Any additional Roth savings beyond the elective deferral limit in such plans, ($22,500 in 2023 plus catchups) must be made through a backdoor Roth IRA contribution, which has a maximum contribution limit of only $6,500 plus $1,000 catchup for those over 50. What many are not aware of, however, is that there might be another backdoor available through their employer retirement plans that puts the classic backdoor Roth IRA to shame. While it’s not available to everyone, the so-called “mega-backdoor Roth IRA” is an exceptionally powerful and tax-efficient retirement savings strategy.
What is a “Backdoor Roth IRA”
The “backdoor Roth IRA” can be used by high income earners to get around the IRS regulations that prevent them from making an ordinary Roth IRA contribution (due to having “too high” of an income). Oftentimes, after maxing out employer retirement plan contributions, a backdoor Roth IRA is the next best place to save for retirement.
A backdoor Roth IRA is nothing more than an after-tax contribution made to a Traditional IRA that has been converted to a Roth IRA. In other words, a backdoor Roth IRA contribution involves making two transactions:
A non-deductible (after-tax) contribution to a Traditional IRA
Conversion of your non-deductible IRA contribution to a Roth IRA
Since the conversion takes place on an after-tax IRA contribution, it is not taxable when it is converted to a Roth. And once in the Roth IRA, it will never be taxed again (assuming all other IRS rules for a qualified Roth distribution are followed). The largest limitation backdoor Roth IRAs face is the contribution limit. Only $6,500 per year may be contributed to a backdoor Roth IRA, plus another $1,000 for those over the age of 50.
What many are not aware of, however, is that this same transaction can sometimes take place inside of an employer retirement plan with an exceptionally higher contribution limit. Due to the high contribution amounts, a backdoor Roth conversion completed within an employer retirement plan is known as a “mega-backdoor Roth IRA”. To make such contributions, your employer retirement plan must allow for both of the following:
Non-Roth after-tax contributions (oftentimes just called “after-tax” contributions)
Roth conversions of plan assets or in-service withdrawals
Non-Roth After-Tax 401(k) Contributions
If you are a high-income earner, then you likely know your annual 401(k) contribution limit ($22,500 in 2023 for all income earners, and $30,000 for those above the age of 50). What you might not know, however, is the maximum that can go into a 401(k) every year is $66,000 ($73,500 if you’re older than 50). This $66,000 is the ceiling for funds that enter the 401(k) from all sources: your contributions, your employer’s matching contributions, employer profit sharing, etc. Most 401(k) participants fall far short of the $66,000 maximum every year. To allow participants to contribute additional funds up to the $66,000 maximum, some employers will allow after-tax contributions to be made to the plan.
After-tax 401(k) contributions are different from pre-tax and Roth contributions. The latter two types of contributions are subject to the $22,500 contribution limit and can’t be made to reach the $66,000 maximum. Furthermore, after-tax contributions are made to a 401(k) on an after-tax basis (obviously), so when they are taken out in retirement, they remain tax free. Growth on those contributions, however, is 100% taxable when distributed (assuming you didn’t utilize the “mega-backdoor” strategy).
Roth Conversions
A Roth conversion is nothing more than the transfer of assets from a pre-tax retirement account (such as a 401(k) or a Traditional IRA) to a Roth retirement account. Contrary to Roth contributions, conversions have no income phaseouts or maximums, making them available to every taxpayer with pre-tax assets.
There are numerous nuances to Roth conversions, meaning you should not try to do them without seeking professional assistance. Trying to DIY these will likely lead to major tax consequences and unnecessary headaches.
The “Mega-Backdoor” Roth Conversion
If you “max out” your 401(k) by contributing up to the $22,500 elective deferral maximum and then contribute additional funds on an after-tax basis, you can then rollover the after-tax contributions to a Roth account! This means that all growth on the funds will be completely tax-free upon their distribution. This is usually done either through an in-service withdrawal of the after-tax funds to a Roth IRA, or an in-plan Roth conversion of the after-tax funds to a Roth 401(k). One thing to be mindful of, however, is that any growth on the after-tax contributions will be taxable as ordinary income upon their rollover to a Roth IRA or conversion to a Roth 401(k). Once in the Roth, however, all funds are protected from future taxation (assuming all other IRS rules are followed). For this reason, “mega-backdoor” conversions/rollovers are usually done soon after the after-tax contributions are made, when growth on the funds is relatively small.
This is a tremendous advantage over the normal tax-treatment of after-tax contributions. Recall that, if left outside of a Roth, then any growth on the after-tax funds will be fully taxable upon their distribution. By taking this one simple step (the facilitation of which you’ve entrusted to a competent professional), you can make all that future growth tax-free.
At the end of the day, you should work with a competent financial professional to see if after-tax contributions to your 401(k) make sense for you.