Mega backdoor Roth to Roth 401k or Roth IRA

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lm
Posts: 32
Joined: Wed May 11, 2011 9:43 pm

Mega backdoor Roth to Roth 401k or Roth IRA

Post by lm » Thu May 24, 2018 1:59 am

My wife’s 401k plan allows her to make unmatched after-tax contributions in addition to the matched pre-tax contributions that are limited to $18,500. These after-tax contributions can then be converted either to a Roth 401k within the same plan, or to external Roth and Traditional IRAs for contributions and earnings, respectively.

To me this sounds like a good way to create tax-advantaged space in addition to our maxed-out pre-tax 401k contributions. There are a few things that are not clear to me:

1. I believe this setup is sometimes called the “mega backdoor Roth” because it would allow us to make significant Roth contributions even though we are over the income limit for regular Roth contributions. For “regular” backdoor Roth conversions one should first dissolve any existing traditional IRA accounts (by rolling them into other retirement plans) in order to avoid unfavorable taxation. Is this true for the mega backdoor Roth conversion as well? Is an existing traditional IRA a concern when doing either (after-tax 401k) -> (Roth 401k) or (after tax 401k) -> (Traditional / Roth IRA) conversions?

2. I have read on this board about the relative advantages of staying within the 401k plan vs. rolling over to external IRAs. From what I understand the IRA route has some advantages (no RMDs, penalty-free withdrawal of Roth contributions below 59-1/2 age limit) over the in-plan rollover. Other than fund availability, are there any additional significant differences between these two options? For example, would using two IRA accounts in addition to the 401k lead to significantly more paperwork and record keeping along the way?

Any advice would be much appreciated.

TheOscarGuy
Posts: 486
Joined: Sat Oct 06, 2012 1:10 pm
Location: MA

Re: Mega backdoor Roth to Roth 401k or Roth IRA

Post by TheOscarGuy » Thu May 24, 2018 6:08 am

lm wrote:
Thu May 24, 2018 1:59 am
My wife’s 401k plan allows her to make unmatched after-tax contributions in addition to the matched pre-tax contributions that are limited to $18,500. These after-tax contributions can then be converted either to a Roth 401k within the same plan, or to external Roth and Traditional IRAs for contributions and earnings, respectively.

To me this sounds like a good way to create tax-advantaged space in addition to our maxed-out pre-tax 401k contributions. There are a few things that are not clear to me:

1. I believe this setup is sometimes called the “mega backdoor Roth” because it would allow us to make significant Roth contributions even though we are over the income limit for regular Roth contributions. For “regular” backdoor Roth conversions one should first dissolve any existing traditional IRA accounts (by rolling them into other retirement plans) in order to avoid unfavorable taxation. Is this true for the mega backdoor Roth conversion as well? Is an existing traditional IRA a concern when doing either (after-tax 401k) -> (Roth 401k) or (after tax 401k) -> (Traditional / Roth IRA) conversions?

2. I have read on this board about the relative advantages of staying within the 401k plan vs. rolling over to external IRAs. From what I understand the IRA route has some advantages (no RMDs, penalty-free withdrawal of Roth contributions below 59-1/2 age limit) over the in-plan rollover. Other than fund availability, are there any additional significant differences between these two options? For example, would using two IRA accounts in addition to the 401k lead to significantly more paperwork and record keeping along the way?

Any advice would be much appreciated.
You can put it directly into roth IRA:

viewtopic.php?f=2&t=137366&p=3672947#p3672947

retiredjg
Posts: 33236
Joined: Thu Jan 10, 2008 12:56 pm

Re: Mega backdoor Roth to Roth 401k or Roth IRA

Post by retiredjg » Thu May 24, 2018 9:04 am

lm wrote:
Thu May 24, 2018 1:59 am
Is this true for the mega backdoor Roth conversion as well? Is an existing traditional IRA a concern when doing either (after-tax 401k) -> (Roth 401k) or (after tax 401k) -> (Traditional / Roth IRA) conversions?
No, not if you do it right.

It is not an issue at all for the in-plan Roth rollover (IRR).

For the mega-back door, if you send the after-tax money DIRECTLY to Roth IRA, what you have in tIRA is irrelevant to the mega-back door. There is no pro-rating. But if you accidentally send the after-tax money to tIRA and convert it to Roth IRA....pro-rating with all tiRA money will happen.

All this assumes you are not also doing the ordinary back door. If you are, there are ways to work around and get them both done.

Other than fund availability, are there any additional significant differences between these two options? For example, would using two IRA accounts in addition to the 401k lead to significantly more paperwork and record keeping along the way?
I think which way you do it is just personal preference. Your money might have more protections inside the 401k in some states.

If you roll out to Roth IRA, you do need to keep up with how every penny gets into your Roth IRA. You will need this information if you take money out of Roth IRA before 59.5. This could be pretty easy - just a sheet of paper or a spreadsheet if you prefer - accompanied by your 1099's and other paperwork you receive each year related to IRAs.

Spirit Rider
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Joined: Fri Mar 02, 2007 2:39 pm

Re: Mega backdoor Roth to Roth 401k or Roth IRA

Post by Spirit Rider » Thu May 24, 2018 9:47 am

lm wrote:
Thu May 24, 2018 1:59 am
1. I believe this setup is sometimes called the “mega backdoor Roth” because it would allow us to make significant Roth contributions even though we are over the income limit for regular Roth contributions. For “regular” backdoor Roth conversions one should first dissolve any existing traditional IRA accounts (by rolling them into other retirement plans) in order to avoid unfavorable taxation. Is this true for the mega backdoor Roth conversion as well? Is an existing traditional IRA a concern when doing either (after-tax 401k) -> (Roth 401k) or (after tax 401k) -> (Traditional / Roth IRA) conversions?
Mega Backdoor Roth Rollovers: Direct in-service rollovers to a Roth IRA are never in a traditional IRA to be counted for Form 8606 pro-rata purposes. You will have both employee after-tax contributions and pre-tax earnings on those contributions. The amount of the pre-tax earnings will affected by any frequency limitations on in-service rollovers. You can roll both over to a Roth IRA paying taxes on any earnings as above.

You can also do a completely tax-free split roller of the after-tax contributions to a Roth IRA and the pre-tax earnings to a traditional IRA. If your plan accepts rollovers, you can then roll the pre-tax traditional IRA back into the 401k by 12/31 to preserve the Backdoor Roth with little to no taxation.
2. I have read on this board about the relative advantages of staying within the 401k plan vs. rolling over to external IRAs. From what I understand the IRA route has some advantages (no RMDs, penalthty-free withdrawal of Roth contributions below 59-1/2 age limit) over the in-plan rollover. Other than fund availability, are there any additional significant differences between these two options? For example, would using two IRA accounts in addition to the 401k lead to significantly more paperwork and record keeping along the way?
Mega In-plan Roth Rollovers: If your plan supports In-plan Roth Rollovers (IRRs), you can make employee after-tax contributions and roll them and any pre-tax earnings to the Roth designated 401k account. The pre-tax earnings will be taxable. There are a couple of benefits of Mega In-plan Roth Rollovers over a Mega Backdoor Roth:
  1. A Roth 401k receives full ERISA Title I anti-alienation asset protection. A Roth IRA's creditor protection is subject to state law. About 10 states do not provide such unlimited protection.
  2. Many 401k plans limit the frequency of in-service rollovers of after-tax contributions and earnings. Many times to just once/year. Most 401k plans supporting IRRs have no frequency restrictions, because IRRs are a participant initiated rollover on-line.
  3. The best of both worlds is if your plan allows in-service rollovers of IRRs from after-tax accounts. You do the IRR of the after-tax contribution immediately after deposit with little to no pre-tax earnings and taxation. Then once a year you can do an in-service rollover of the after-tax IRRs to a Roth IRA.

lm
Posts: 32
Joined: Wed May 11, 2011 9:43 pm

Re: Mega backdoor Roth to Roth 401k or Roth IRA

Post by lm » Thu May 24, 2018 2:57 pm

TheOscarGuy wrote:
Thu May 24, 2018 6:08 am

You can put it directly into roth IRA:

viewtopic.php?f=2&t=137366&p=3672947#p3672947
I am not sure I understand: I thought that since we are over the income limit we cannot contribute directly to a Roth IRA, so we would have to use one of the backdoor routes. Doesn't the post you linked to imply that while one can still open a Roth IRA, all contributions have to go through the employer's 401k plan as after-tax contributions first?

cherijoh
Posts: 4858
Joined: Tue Feb 20, 2007 4:49 pm
Location: Charlotte NC

Re: Mega backdoor Roth to Roth 401k or Roth IRA

Post by cherijoh » Thu May 24, 2018 3:18 pm

lm wrote:
Thu May 24, 2018 2:57 pm
TheOscarGuy wrote:
Thu May 24, 2018 6:08 am

You can put it directly into roth IRA:

viewtopic.php?f=2&t=137366&p=3672947#p3672947
I am not sure I understand: I thought that since we are over the income limit we cannot contribute directly to a Roth IRA, so we would have to use one of the backdoor routes. Doesn't the post you linked to imply that while one can still open a Roth IRA, all contributions have to go through the employer's 401k plan as after-tax contributions first?
There are different rules for after-tax contributions to a 401k plan than for non-deductible contributions to an IRA. If you are above the income limits for a Roth IRA and you want to contribute via IRA then you must go the Back Door Roth route - open a non-deductible traditional IRA and convert it to a Roth using the pro-rata rules on Form 8606.

Not every 401k accepts after-tax (i.e., non-Roth) contributions and even if they do, not all are set up for in-service withdrawals. However, IF your plan does allow for after-tax contributions AND in-service rollovers to a Roth 401k or Roth IRA, then you have a straightforward path to a Roth IRA bypassing the traditional IRA altogether.

lm
Posts: 32
Joined: Wed May 11, 2011 9:43 pm

Re: Mega backdoor Roth to Roth 401k or Roth IRA

Post by lm » Thu May 24, 2018 3:39 pm

Thank you all for your responses; they are very helpful. My wife's 401k plan allows automatic quarterly in-plan Roth conversion of after-tax contributions, which seems very convenient. I might prefer that route just for its simplicity.

I am still unsure about the ability to withdraw money from Roth IRA and Roth 401k before reaching age 59-1/2. My current understanding is the following:
  1. If the after-tax contributions are converted to a Roth IRA, then the contributions (but not the earnings) can be withdrawn tax- and penalty free (assuming that 5 years have passed since the first contribution was made). Earnings can be withdrawn but would be subject to income tax and an early-withdrawal penalty (with some exceptions).
  2. If the after-tax contributions are rolled over in-plan to a Roth 401k and my wife terminates employment with this employer, then that money can be rolled over to a Roth IRA, leaving us essentially in the same position as above.
  3. If the after-tax contributions are rolled over in-plan to a Roth 401k and my wife still works for this employer, then I am not sure what happens. I read that one can still make withdrawals before 59-1/2, but that one would have to pay income tax on the fraction of the withdrawal that correspond to earnings in the account. Is that correct? Would one similarly have to pay an early-withdrawal penalty only on the fraction that corresponds to earnings?

retiredjg
Posts: 33236
Joined: Thu Jan 10, 2008 12:56 pm

Re: Mega backdoor Roth to Roth 401k or Roth IRA

Post by retiredjg » Thu May 24, 2018 4:15 pm

It is a very complex and confusing system.
lm wrote:
Thu May 24, 2018 3:39 pm
[*]If the after-tax contributions are converted to a Roth IRA, then the contributions (but not the earnings) can be withdrawn tax- and penalty free (assuming that 5 years have passed since the first contribution was made). Earnings can be withdrawn but would be subject to income tax and an early-withdrawal penalty (with some exceptions).
Not quite.

There is no 5 year wait since the first contribution was made.

There is an order assigned to how things can come out of the Roth IRA.
  • 1) Direct (ordinary Roth IRA) contributions are available any time for any reason with no tax and no penalty (and no 5 year wait).

    2) Then come your conversions (back door, mega back door) oldest first; If anything was taxed at the time of the conversion, that portion has a 5 tax year clock. If you take that money out before the clock has run, there is a 10% penalty but no tax (because you paid tax when you did the conversion). The part that had already been taxed before it got into the Roth IRA (your after-tax contributions) does not have a 5 year clock but you cannot take it until you take the part that does have the clock (which is likely to be small - not a huge hurdle).

    3) This goes on year after year if you do conversions/rollover from after-tax account year after year

    4) Finally, the last thing to come out of Roth IRA are the earnings that have occurred inside the Roth IRA
In your case, since you plan to send the earnings part of the after tax account to tIRA (not Roth IRA), nothing will be taxed at that rollover. So your after-tax money becomes availlble any time for any reason with no tax or penalty.

[*]If the after-tax contributions are rolled over in-plan to a Roth 401k and my wife terminates employment with this employer, then that money can be rolled over to a Roth IRA, leaving us essentially in the same position as above.
Can't help with this one - only Alan S (and maybe Spirit Rider?) seems to know.
[*]If the after-tax contributions are rolled over in-plan to a Roth 401k and my wife still works for this employer, then I am not sure what happens. I read that one can still make withdrawals before 59-1/2, but that one would have to pay income tax on the fraction of the withdrawal that correspond to earnings in the account. Is that correct? Would one similarly have to pay an early-withdrawal penalty only on the fraction that corresponds to earnings?
Same as just above. :happy

I didn't do a very good job of explaining that first one. Let me know if you need an example.

lm
Posts: 32
Joined: Wed May 11, 2011 9:43 pm

Re: Mega backdoor Roth to Roth 401k or Roth IRA

Post by lm » Fri May 25, 2018 12:57 am

retiredjg, thank you so much for your clear explanations; they have been extremely helpful.

It seems that the combination of external Roth and traditional IRAs has a few minor advantages, but the simplicity of doing automated in-plan rollovers is very tempting. Decisions, decisions...

TheOscarGuy
Posts: 486
Joined: Sat Oct 06, 2012 1:10 pm
Location: MA

Re: Mega backdoor Roth to Roth 401k or Roth IRA

Post by TheOscarGuy » Fri May 25, 2018 5:48 am

Spirit Rider wrote:
Thu May 24, 2018 9:47 am

You can also do a completely tax-free split roller of the after-tax contributions to a Roth IRA and the pre-tax earnings to a traditional IRA. If your plan accepts rollovers, you can then roll the pre-tax traditional IRA back into the 401k by 12/31 to preserve the Backdoor Roth with little to no taxation.
Thanks, I did not know that! it may be useful to those who have too much earnings, due to their plan not offering in service rollovers frequently. Is this advisable over rolling over contribution + earnings into roth IRA and pay tax at the time? What are the differences apart from mechanics stated above? Do we need to maintain any more of less paperwork going forward?

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