Paying as little taxes as legally possible is as American as Moms, Guns, and Apple Pies. If you follow this blog, you know that one of the easiest and best ways to reduce your taxes both now and in the future is to contribute as much as you possibly can to retirement accounts like 401ks, IRAs, etc. Unfortunately, those accounts have annual limits on how much you can contribute. But what if you could contribute a lot more? I mean A LOT more… Think tax loopholes are only for the 1%ers? Think again. I bring you: The MEGA Backdoor Roth.
You may have heard of a “Backdoor Roth“. It’s a loophole that allows above-average income earners to contribute to Roth IRAs, even though they are supposedly not eligible to contribute to Roth IRAs. But one of the biggest problems with Backdoor Roths is that they have restrictive contribution limits – $5,500 in 2017 for most of us, or $6,500 if you’re over 50. What if you want to contribute more?
The MEGA Backdoor Roth
The MEGA Backdoor Roth is initiated through 401k plans, rather than IRAs. In a nutshell, the process involves two steps:
- Make up to $36,000 (in 2017) in after-tax contributions into your 401k, which are above and beyond the normal 401k individual contribution limit ($18,000 in 2017).
- Rollover that after-tax contribution into a Roth 401k or a Roth IRA.
Voila! You’ve just contributed $36,000 to a Roth, even though you’re not allowed to contribute so much to a Roth (but you are!). Don’t you love loopholes?
The big caveat is that you can only do this if a) your 401k plan rules allow for after-tax contributions, and b) either your 401k plan allows in-service rollovers or you plan to quit your job sometime in the nearish future, in which case you can rollover regardless.
Unfortunately, most 401k plans currently don’t allow after-tax contributions, which prevents most of us from doing MEGA Backdoor Roths. But, that may be changing. The IRS rule (2014-54) that explicitly allows for MEGA Backdoor Roths was only published in 2014, and as awareness of the strategy grows, more companies are starting to allow it in their 401k plans. I predict that in 10 years, many more of us will be able to MEGA.
First, What Is An After-Tax Contribution
If you are familiar with 401ks you probably have heard of three different types of money. There are your pre-tax employee contributions, and Roth contributions, which are limited to $18,000 per individual per year (in 2017). Third, you may have employer matching contributions. The combined total of your employee contributions and your employer matching can be up to $54,000 total per individual in 2017.
But, there is another type of 401k contribution you probably have never heard of – the after-tax employee contribution. It doesn’t reduce your taxes in the year you contribute, and also the earnings do not grow tax-free. So, it’s kind of like an ugly offspring of the pre-tax employee contributions and the Roth contributions – the worst aspects of both.
But, this offspring has a silver lining: the amount is only limited in size by the $54,000 total account contribution limit (in 2017). That means you can contribute up to $36,000 of after-tax contributions (in 2017) on top of your $18,000 of pre-tax or Roth contributions.
There would be little reason to do this if you could not subsequently move that after-tax contribution into a Roth account where it can grow unharmed for years by the tax gods. Fortunately, you can, under the rules set forth in IRS 2014-54.
Why the MEGA Backdoor Roth is Massively Better
There are three important advantages the MEGA Backdoor Roth has over the regular “Backdoor Roth“:
- First, and foremost, the contribution limits: The regular Backdoor Roth only allows you to backdoor $5,500 (in 2017), while the MEGA allows up to $36,000 (in 2017).
- Second, the regular Backdoor Roth is a bit shady. It’s a loophole that bends the rules, just a bit. Rumor has it that the regular Backdoor Roth will be closed by Congress…. (any day now?)…. The MEGA, on the other hand, is explicitly allowed via IRS rule 2014-54. That makes it more of a sure-thing in the “Are-You-Sure-This-Is-Even-Legal?” department.
- Third, the MEGA Backdoor Roth is open to all-comers. The regular Backdoor Roth only works for people in certain above-average income brackets, but the MEGA has no limitations based on income. You just need access to a 401k plan that allows it.
Be Careful, The Rollover Can Bite
Just like the regular Backdoor Roth, you can incur unnecessary taxes on a MEGA Backdoor Roth if you’re not careful with the rollover. Specifically, you cannot only roll-over the after-tax contributions, and leave the remainder in your 401k. Any partial rollover from your 401k must be treated as a pro-rata combination of the different types of contributions in your account: pre-tax and after-tax. However, you are allowed to do a single rollover to multiple destinations. This means you can roll over your pretax amounts to a traditional IRA or retirement plan and your after-tax amounts to a different destination, such as a Roth IRA. If you do the allocations properly, you will avoid taxes on your rollover.
Be careful here. How much you can rollover into each account type depends on your specific situation. You can read more about rollover allocation rules here.
But, alas, since few 401k plans currently allow after-tax contributions, few people can take advantage of this awesome loophole. You are at the mercy of your company’s 401k plan rules.
Self-employed individuals are the luckiest of all because they have access to the best retirement account around: the solo 401k. One advantage of a Solo 401k is that you can write your own rules of the plan. This means you can create a Solo 401k for yourself that allows for MEGA Backdoor Roths.
This is kind of black-belt stuff. Most people who have Solo 401ks use the “canned” plans offered by major investment fund companies like Vanguard and Fidelity. These “canned” Solo 401ks don’t currently allow for MEGA Backdoor Roths. So, you essentially have to create your own plan and administer it yourself or hire a third-party administrator – It’s not something many people want to sign up for.
Why It May Not Matter For Self Employed Workers
But, it’s all good – if you’re self employed or have a side hustle, it may not matter whether you can MEGA or not. If your self-employment income is below $54,000, then any 401k contributions you make are limited by your income. This is where I am. We only make about $30,000-$40,000 per year from our garage business. So we cannot take full advantage of a MEGA Backdoor Roth, especially after splitting income between me and my wife. In our case, we’re happy with a “canned” solo 401k from Vanguard.
Similarly, on the high-end, if you make about $200,000 from self-employment, then it doesn’t matter. You can contribute the full $54,000 to your solo 401k without the need to be back-dooring your Roth.
Even those in the Goldilocks middle income range ($54,000 – $200,000) may have better options than a MEGA Backdoor Roth. For example, if you’re covered by a 401k at work, and you have a side income, you may do better by using an SEP IRA for your side hustle, rather than a solo 401k – and again have no need to do a MEGA Backdoor Roth.
For more information about Solo 401k contribution limits: https://www.irs.gov/retirement-plans/one-participant-401k-plans
To understand more about rollover rules: https://www.irs.gov/retirement-plans/rollovers-of-after-tax-contributions-in-retirement-plans
For all the gory details about MEGA Backdoor Roth conversion rules, see here: https://www.irs.gov/pub/irs-drop/n-14-54.pdf
In the meantime, if you’re a worker drone and your 401k plan at work does not allow for after-tax contributions or in-service rollovers, I encourage you to pester your HR rep about adding these features. Every single day.