Mega Backdoor Roth Priority

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CaliforniaRocketFuel
Posts: 2
Joined: Fri Dec 07, 2018 11:32 am
Location: Mesa, AZ

Mega Backdoor Roth Priority

Post by CaliforniaRocketFuel » Fri Dec 07, 2018 12:13 pm

I generally follow advice from https://www.bogleheads.org/wiki/Priorit ... nvestments in choosing where to invest my money.

However, my company just announced some changes to our 401k plan. Among them is the ability make after-tax contributions with a possibility of doing a mega backdoor Roth conversion. I am now torn between investing in a taxable account or taking advantage of the mega backdoor Roth. On the one hand, I feel like investing in a taxable account offers more flexibility with being able to pull money out early. I'm not at a point where I can max out the after-tax 401k contributions and invest in a taxable account at the same time. Maybe I should split the contributions.

Any thoughts on this?

Alan S.
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Joined: Mon May 16, 2011 6:07 pm
Location: Prescott, AZ

Re: Mega Backdoor Roth Priority

Post by Alan S. » Fri Dec 07, 2018 12:44 pm

What are your options with the after tax contributions?

How often can you convert them? Can you do a direct rollover to your Roth IRA, or must you do an in plan Roth rollover (IRR) to your Roth 401k account? Or do you have a choice? If you are required to do an IRR (no option to distribute to your Roth IRA), then you designated Roth account is probably tied up until you separate from service.

If you find that you can do direct rollovers to your Roth IRA, you will have easy access to the Roth IRA money. After you have withdrawn all your Roth IRA regular contributions, then you start tapping conversions starting with the oldest. Conversions under 5 years incur a 10% penalty if withdrawn, but ONLY on the taxable amount of the conversion (includes direct rollovers from 401k after tax money). Since only a small portion of these rollovers (earnings generated before you can do the rollover) are taxable, the 10% penalty would only apply to this small taxable portion.

Example:
You make after tax 401k contributions of 10,000 and are allowed to roll out to a Roth IRA every 6 months. Your first rollover of 5000 of your contributions has earned $300 so that is the taxable amount. 6 months later you do another and this one earned $400. For the year you will be taxed on $700 of the 10,700 rolled to your Roth IRA. If you later withdraw this conversion from your Roth IRA within 5 years, you will owe the 10% on the first $700 for a penalty of $70. So the tax cost is not much for getting this much into your Roth IRA, and perhaps you have regular contributions in your Roth IRA OR older Roth conversion from a basic back door which are over 5 years already or also had a very low taxable amount.

You are the only one in a position to determine what your chances of needing this money are. If you are sure you will need it soon, perhaps save that much in taxable (also subject to taxable interest, dividends, cap gains etc) and use the mega back door for the rest. If you will NOT be able to roll the money out to your Roth IRA, the mega back door is less appealing unless you are very sure you will not need the money before separation.

PolarBearMarket
Posts: 41
Joined: Thu Sep 13, 2018 11:52 am

Re: Mega Backdoor Roth Priority

Post by PolarBearMarket » Fri Dec 07, 2018 12:46 pm

CaliforniaRocketFuel wrote:
Fri Dec 07, 2018 12:13 pm
I generally follow advice from https://www.bogleheads.org/wiki/Priorit ... nvestments in choosing where to invest my money.

However, my company just announced some changes to our 401k plan. Among them is the ability make after-tax contributions with a possibility of doing a mega backdoor Roth conversion. I am now torn between investing in a taxable account or taking advantage of the mega backdoor Roth. On the one hand, I feel like investing in a taxable account offers more flexibility with being able to pull money out early. I'm not at a point where I can max out the after-tax 401k contributions and invest in a taxable account at the same time. Maybe I should split the contributions.

Any thoughts on this?
With a Roth IRA, you can withdraw the principle without penalty. The only benefit in going taxable is that you can withdraw the earnings early for any reason and 'only' pay capital gains vs paying a 10% penalty + income tax.

Do you expect to need the money for something soon?

panhead
Posts: 311
Joined: Fri Feb 22, 2013 10:53 am

Re: Mega Backdoor Roth Priority

Post by panhead » Fri Dec 07, 2018 12:48 pm

CaliforniaRocketFuel wrote:
Fri Dec 07, 2018 12:13 pm
I generally follow advice from https://www.bogleheads.org/wiki/Priorit ... nvestments in choosing where to invest my money.

However, my company just announced some changes to our 401k plan. Among them is the ability make after-tax contributions with a possibility of doing a mega backdoor Roth conversion. I am now torn between investing in a taxable account or taking advantage of the mega backdoor Roth. On the one hand, I feel like investing in a taxable account offers more flexibility with being able to pull money out early. I'm not at a point where I can max out the after-tax 401k contributions and invest in a taxable account at the same time. Maybe I should split the contributions.

Any thoughts on this?
As long as you have an adequate emergency fund, I think its a great idea to max out your after tax 401k/Mega Roth. If you are rolling the after tax account to a Roth IRA every year, after 5 years (make sure you understand the rules perfectly) you can withdraw the original roll over amount tax and penalty free. Note that each rollover will have its own clock. I know I am oversimplifying this, but you can search the forum for the exact rules. Look for anything by AlanS.

There are several advantages to using the Mega instead of a taxable account. Some I can think of off the top of my head:

1) Retirement accounts often have better protection than taxable accounts from creditors.
2) Investing in the Mega Roth won't create any tax drag like you can get with a taxable account
3) Easy. Payroll deductions make this brainless so you won't be tempted to spend the money
4) Tax Diversification: None of us know what taxes will look like when we retire, so a nice helping of taxable, tax deferred, and tax free will likely be helpful

This goes without saying that if you are saving for a particular goal like a home down payment, than this is not the appropriate place. Other than that, this is usually considered a bit better for investing than a taxable account.

-Pan-

ETA: AlanS beat me to it! I was steering you to search for posts by him above.

SRenaeP
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Joined: Tue Jan 19, 2010 9:05 pm

Re: Mega Backdoor Roth Priority

Post by SRenaeP » Fri Dec 07, 2018 2:15 pm

I split contributions between taxable and the mega backdoor. My 401k only allows for in-plan Roth conversions without penalty, not in service withdrawals. I like the flexibility of being able to access the taxable funds when/if I want.

CaliforniaRocketFuel
Posts: 2
Joined: Fri Dec 07, 2018 11:32 am
Location: Mesa, AZ

Re: Mega Backdoor Roth Priority

Post by CaliforniaRocketFuel » Fri Dec 07, 2018 2:56 pm

Thanks everyone for the advice. I don't have all of the details from my employer yet but it sounds like it might be in-plan Roth rollover only. I was also under the impression that you paid a lot more in taxes when converting after-tax 401k contributions to Roth, but it sounds like you pay only on the gains while it was in your 401k account as an after-tax contribution? Some of the literature I've read made me think otherwise.

SRenaeP
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Joined: Tue Jan 19, 2010 9:05 pm

Re: Mega Backdoor Roth Priority

Post by SRenaeP » Fri Dec 07, 2018 3:42 pm

CaliforniaRocketFuel wrote:
Fri Dec 07, 2018 2:56 pm
Thanks everyone for the advice. I don't have all of the details from my employer yet but it sounds like it might be in-plan Roth rollover only. I was also under the impression that you paid a lot more in taxes when converting after-tax 401k contributions to Roth, but it sounds like you pay only on the gains while it was in your 401k account as an after-tax contribution? Some of the literature I've read made me think otherwise.
After tax means just that. You've already paid taxes on the money going in. So yes, you would only be taxed on any gains that are rolled over.

Pigeye Brewster
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Joined: Thu Oct 05, 2017 7:33 pm

Re: Mega Backdoor Roth Priority

Post by Pigeye Brewster » Fri Dec 07, 2018 3:51 pm

CaliforniaRocketFuel wrote:
Fri Dec 07, 2018 2:56 pm
Thanks everyone for the advice. I don't have all of the details from my employer yet but it sounds like it might be in-plan Roth rollover only. I was also under the impression that you paid a lot more in taxes when converting after-tax 401k contributions to Roth, but it sounds like you pay only on the gains while it was in your 401k account as an after-tax contribution? Some of the literature I've read made me think otherwise.
What you may have read about was if you aren't able to convert the after-tax contributions to Roth, either in-plan Roth or a Roth IRA. Not all plans that allow after-tax contribution also allow in-service distributions or in-plan Roth rollovers. In that situation, it may be better to invest in taxable rather than after-tax 401k, since gains in taxable would be taxed at favorable capital gains tax rates while withdrawal of after-tax 401k gains would be ordinary income.

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FiveK
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Re: Mega Backdoor Roth Priority

Post by FiveK » Sat Dec 08, 2018 2:14 pm

CaliforniaRocketFuel wrote:
Fri Dec 07, 2018 12:13 pm
I generally follow advice from https://www.bogleheads.org/wiki/Priorit ... nvestments in choosing where to invest my money.
See also Investment Order for a similar but more detailed set of suggestions.

In short, only you can decide the amount of your savings/investments needed for short vs. long term spending. The longer term your outlook, the more a mega backdoor Roth is likely preferable to taxable accounts.

SRenaeP
Posts: 773
Joined: Tue Jan 19, 2010 9:05 pm

Re: Mega Backdoor Roth Priority

Post by SRenaeP » Mon Dec 10, 2018 8:40 am

FiveK wrote:
Sat Dec 08, 2018 2:14 pm
CaliforniaRocketFuel wrote:
Fri Dec 07, 2018 12:13 pm
I generally follow advice from https://www.bogleheads.org/wiki/Priorit ... nvestments in choosing where to invest my money.
See also Investment Order for a similar but more detailed set of suggestions.

In short, only you can decide the amount of your savings/investments needed for short vs. long term spending. The longer term your outlook, the more a mega backdoor Roth is likely preferable to taxable accounts.
This is an interesting perspective. Will you elaborate? 2019 is the first year it *might* be possible for me to max out the mega backdoor. (Note I can't do in-service withdrawals, only in plan conversion so it would be a Roth 401k not Roth IRA). If I did max it out, it would be at the expense of my taxable account. As of now, I decided to keep contributing to the taxable account so I wouldn't lock up my funds for an indeterminate amount of time. However, I'm open to a dissenting viewpoint.

youngpleb
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Location: VA, USA

Re: Mega Backdoor Roth Priority

Post by youngpleb » Mon Dec 10, 2018 9:43 am

CaliforniaRocketFuel wrote:
Fri Dec 07, 2018 12:13 pm
I generally follow advice from https://www.bogleheads.org/wiki/Priorit ... nvestments in choosing where to invest my money.

However, my company just announced some changes to our 401k plan. Among them is the ability make after-tax contributions with a possibility of doing a mega backdoor Roth conversion. I am now torn between investing in a taxable account or taking advantage of the mega backdoor Roth. On the one hand, I feel like investing in a taxable account offers more flexibility with being able to pull money out early. I'm not at a point where I can max out the after-tax 401k contributions and invest in a taxable account at the same time. Maybe I should split the contributions.

Any thoughts on this?
I struggle with the same predicament. I think it comes down to at what age you will be retiring. Retiring at an age when you could easily access your tax-advantaged accounts makes the MBR seem like the clear winner. If you are planning to retire early, then you might want the taxable investments to help get you to the age when you can access your tax-advantaged assets.
27. Always learning.

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FiveK
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Re: Mega Backdoor Roth Priority

Post by FiveK » Mon Dec 10, 2018 11:47 am

SRenaeP wrote:
Mon Dec 10, 2018 8:40 am
FiveK wrote:
Sat Dec 08, 2018 2:14 pm
See also Investment Order for a similar but more detailed set of suggestions.
In short, only you can decide the amount of your savings/investments needed for short vs. long term spending. The longer term your outlook, the more a mega backdoor Roth is likely preferable to taxable accounts.
This is an interesting perspective. Will you elaborate? 2019 is the first year it *might* be possible for me to max out the mega backdoor. (Note I can't do in-service withdrawals, only in plan conversion so it would be a Roth 401k not Roth IRA). If I did max it out, it would be at the expense of my taxable account. As of now, I decided to keep contributing to the taxable account so I wouldn't lock up my funds for an indeterminate amount of time. However, I'm open to a dissenting viewpoint.
If you expect to need the money (a common example is "for a house down payment") within a few years, favoring a taxable account makes sense: there is no penalty to withdraw the entire amount of contributions and earnings.

If you don't expect to need the money within a few years, taking advantage of tax free growth in the Roth seems preferable. Any financial emergency would likely include loss of the job, so the contribution amounts (not the earnings) would be immediately unlocked penalty-free. The slice of events in which one has a financial emergency but not a job loss, assuming one has established a separate emergency fund, is a very narrow slice indeed.

Is that the type of elaboration sought?

SRenaeP
Posts: 773
Joined: Tue Jan 19, 2010 9:05 pm

Re: Mega Backdoor Roth Priority

Post by SRenaeP » Mon Dec 10, 2018 12:59 pm

FiveK wrote:
Mon Dec 10, 2018 11:47 am
SRenaeP wrote:
Mon Dec 10, 2018 8:40 am
FiveK wrote:
Sat Dec 08, 2018 2:14 pm
See also Investment Order for a similar but more detailed set of suggestions.
In short, only you can decide the amount of your savings/investments needed for short vs. long term spending. The longer term your outlook, the more a mega backdoor Roth is likely preferable to taxable accounts.
This is an interesting perspective. Will you elaborate? 2019 is the first year it *might* be possible for me to max out the mega backdoor. (Note I can't do in-service withdrawals, only in plan conversion so it would be a Roth 401k not Roth IRA). If I did max it out, it would be at the expense of my taxable account. As of now, I decided to keep contributing to the taxable account so I wouldn't lock up my funds for an indeterminate amount of time. However, I'm open to a dissenting viewpoint.
If you expect to need the money (a common example is "for a house down payment") within a few years, favoring a taxable account makes sense: there is no penalty to withdraw the entire amount of contributions and earnings.

If you don't expect to need the money within a few years, taking advantage of tax free growth in the Roth seems preferable. Any financial emergency would likely include loss of the job, so the contribution amounts (not the earnings) would be immediately unlocked penalty-free. The slice of events in which one has a financial emergency but not a job loss, assuming one has established a separate emergency fund, is a very narrow slice indeed.

Is that the type of elaboration sought?
Yes, so thank you.

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