Leverage Your 401(k) to Build Roth Earnings

Posted on September 3rd, 2019

Many investors are familiar with the “Backdoor Roth” IRA, which is an indirect way to contribute to a Roth when they are not eligible to contribute directly due to income limitations on Roth investors. Even in those circumstances, some investors can take advantage of a lesser-known Roth contribution dubbed the “Mega Backdoor Roth.”

It’s called “mega” because it allows plan participants to contribute an additional $37,000 into a Roth IRA by leveraging the fact that some employer 401(k) plans allow after-tax contributions up to the current limit of $56,000 ($62,000 for age 50 and older).  The after-tax contributions are not considered Roth contributions, but rather traditional after-tax contributions to the plan. These contributions can be converted to a Roth IRA for tax-free growth.

After-tax contributions into a traditional 401(k) are not tax deductible. The earnings grow tax-deferred, but not tax free.  This means that earnings will be taxed as ordinary income upon withdrawal.

In a direct Roth 401(k) contribution, a participant has paid tax on the contribution and all following earnings and withdrawals are tax-free.  If a participant converts their after-tax contribution and earnings to a Roth 401(k), at the time of conversion, the earnings on the after-tax contribution are taxable.  After the money is in the Roth account, earnings and withdrawals will be tax free.

Consider a Mega Backdoor Roth Contribution if You:

  • ​Currently max out both your 401(k) deferral, and your IRA contribution. For 2019, this means deferring $19,000 ($24k for age 50 and over) to your 401(k) and contributing $6,000 ($7k for age 50 and over) to your IRA. If you can’t deduct your traditional IRA contributions or contribute directly to a Roth IRA due to income limitations.
  • Your employer offers after-tax 401k contributions.
  • You determine that you still have money to save. Consider all of your retirement accounts and the tax benefits they each offer, as well as your overall savings plan and cash-flow needs.

How to Make a Mega Backdoor Roth Contribution

Your 401k plan must offer two features:

  1. After-Tax Contributions above the $19,000 elective deferral limits ($19k is the maximum deferral for pre-tax and Roth combined in 2019).
  2. In-plan Roth rollovers or in-service distributions

To find out if these features are offered in your plan, contact your plan administrator.  This information is available in the Summary Plan Description that you should receive on an annual basis.

If your plan allows after-tax contributions and has a designated Roth account within the plan, the after-tax (non-deductible) contributions can be converted to the Roth account in the plan. Your employer is allowing you to make an in-plan Roth rollover where you can convert your traditional 401(k) to a Roth 401(k).

If your plan allows after-tax contributions and in-service withdrawals (but not in-plan rollovers), you also can make an in-service distribution to a Roth IRA.

Remember, in both scenarios the earnings on the after-tax contributions become taxable at the time of the conversion or distribution.  Ideally, you will convert the funds to the Roth 401(k) fairly soon after making the after-tax contribution, so there aren’t a lot of earnings subject to tax.

Mega Backdoor Roth Contribution Limits

The $56k (or $62k for ages 50 and over) total contribution limit includes employee elective deferrals, the employer match, employer profit sharing contributions, and the after-tax traditional employee contributions.  You will have to find out exactly how much will be contributed by your employer during the year in order to determine the maximum amount your after-tax contribution can be.

After-tax contributions also may be limited by non-discrimination testing.  You will want to speak with your plan administrator or HR person regarding any limits.