mega backdoor Roth -- why not stay in the roth 401(k)

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leftcoaster
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mega backdoor Roth -- why not stay in the roth 401(k)

Post by leftcoaster » Mon Jun 18, 2018 9:26 am

Guidance on the mega backdoor roth for employees typically advocates for doing periodic rollovers from the after-tax Roth 401(k) to a Roth IRA. For example, the White Coat Investor says
It isn’t a particularly good deal to just contribute after-tax money, UNLESS you can then get that money out and convert it to a Roth.
source

However, the rollover amount includes whatever earnings were gained during the time contributions were made to the Roth 401(k). Typically these are small if done periodically and kept in cash-equivalents. Also, one can direct those amounts to a traditional IRA, though that interfaces with the conventional backdoor Roth's goal of being tax free on the conversion. One can alternatively send the earnings into the Roth IRA, but must pay tax on the earnings at the marginal rate. The amounts are small, but non-zero.

Another casualty of the conversion from the after-tax Roth 401(k) to a Roth IRA is that one loses access to the exemption from the 10% penalty on unqualified distributions if one retires during or after the year of reaching age 55. Withdrawals are not qualified from the Roth IRA before age 59.5, but 401(k) plans enjoy a 55+ exception if you are separated from the employer sponsoring the plan in or after the year you become 55.

So, my question: assuming that one has access to portfolio-compatible, low expense funds in the Roth 401(k), why not leave the money in the plan at least until distributions become qualified? My megacorp offers institutional Vanguard funds at super low expense ratios and also offers an in-plan brokerage account option. I would pay no rollover-associated tax, I wouldn't need to hide out in cash (read: can be invested in alignment with my IPS from the moment the Roth 401(k) dollars arrive in the plan) until the rollover. And I'd have access to the plan money without penalty if I separate at age 55+. (note: separating before age 55 and then reaching age 55 is not enough!) I'd also be able to take loans against the 401(k), which I cannot do with a Roth IRA.

What is the purpose of adding in the rollover? It seems like it would introduce: a small, but nonzero high marginal tax hit; some paperwork annoyances; loss of loan-taking ability; and loss of the 55+ exemption on qualified withdrawals.

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walletless
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Re: mega backdoor Roth -- why not stay in the roth 401(k)

Post by walletless » Mon Jun 18, 2018 9:34 am

There is nothing wrong with rolling over to Roth 401k as long as you're aware and ok with one other difference: Your balance in 401K (Roth or traditional) is subject to Required Minimum Distributions (RMD), whereas Roth IRA is not.

My strategy is to keep rolling into Roth 401k for now to take advantage of low cost funds options. However I plan to rollover my Roth 401k to Roth IRA before my retirement.

retiredjg
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Re: mega backdoor Roth -- why not stay in the roth 401(k)

Post by retiredjg » Mon Jun 18, 2018 9:36 am

It does not make sense to you because you are misunderstanding what the "mega back door" is.

To use the mega back door, the money does not start out in Roth 401k. The money starts in an after tax account of a 401k or similar plan.

It is confusing because Roth 401k is "after tax" but it is not the same thing as an "after tax account". In fact, not all plans even offer an after tax account option.

To use the mega back door, one either rolls the after tax account out to Roth IRA or rolls it into Roth 401k.

With this in mind, go back and read the article again and see if you still have questions.

retiredjg
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Re: mega backdoor Roth -- why not stay in the roth 401(k)

Post by retiredjg » Mon Jun 18, 2018 9:37 am

BTW...money in Roth 401k CANNOT be rolled anywhere as long as you are still working for that employer.

Edit. Let me clarify. Money that is part of a person's elective deferrals (the $18.5k) must stay in the 401k (even the designated Roth 401k account) until separation or 59.5 if the plan allows withdrawal at that age.

I believe that money that got into Roth 401k through the mega back door process can be rolled out prior to separation or 59.5.

The point I'm trying to make is that this poster's contributions to Roth 401k (the $18.5k) cannot be used for the "mega back door".
Last edited by retiredjg on Mon Jun 18, 2018 11:06 am, edited 1 time in total.

foo.c
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Re: mega backdoor Roth -- why not stay in the roth 401(k)

Post by foo.c » Mon Jun 18, 2018 10:23 am

Some plans allow in service distributions if you are over 59.5.

retiredjg
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Re: mega backdoor Roth -- why not stay in the roth 401(k)

Post by retiredjg » Mon Jun 18, 2018 11:02 am

foo.c wrote:
Mon Jun 18, 2018 10:23 am
Some plans allow in service distributions if you are over 59.5.
This is correct, but our poster has already indicated a younger age than that. But I could have worded that better. :happy

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Earl Lemongrab
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Re: mega backdoor Roth -- why not stay in the roth 401(k)

Post by Earl Lemongrab » Mon Jun 18, 2018 11:42 am

As noted, you're mixing up terms. The after-tax contributions in the Mega Backdoor are not Roth. Roth contributions are combined with pretax and limited to 18.5k currently. The after-tax is in addition to that, amount limited by the overall plan limits of 55k (combined with employer contributions). This allows extra to go into Roth in some form.

The choices are to convert to Roth 401(k) or roll over to Roth IRA. The former is easy if the plan allows, but you aren't allowed to split the earnings off. You pay tax on their conversion regardless. Also the plan has to have Roth. Megacorp had after-tax way before it had Roth. And of course your investment choices are whatever the plan provides.

With the latter, assuming the plan allows rollovers, you can split the earnings and either keep them in TIRA or as I have done in the past roll them back into the 401(k). The plan has to support that.

Even when Roth became available, I wanted to roll the after-tax out. That because I use my Roth IRA to hold things that should be in tax-advantaged but aren't available in the 401(k), such as value funds and REIT.
This week's fortune cookie: "Your financial life will be secure and beneficial." So I got that going for me, which is nice.

sailaway
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Re: mega backdoor Roth -- why not stay in the roth 401(k)

Post by sailaway » Mon Jun 18, 2018 12:21 pm

Are you aware that you can withdraw your Roth IRA conversions after 5 years, penalty free? In this sense, the Roth IRA might be more flexible than the Roth 401k for those retiring prior to 59.5.

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Silly Wabbit
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Re: mega backdoor Roth -- why not stay in the roth 401(k)

Post by Silly Wabbit » Mon Jun 18, 2018 12:28 pm

sailaway wrote:
Mon Jun 18, 2018 12:21 pm
Are you aware that you can withdraw your Roth IRA conversions after 5 years, penalty free? In this sense, the Roth IRA might be more flexible than the Roth 401k for those retiring prior to 59.5.
Even prior to 5 years, you may withdraw the basis tax and penalty free. Only the portion taxed at conversion would be subject to penalty taxes.

Engineer250
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Re: mega backdoor Roth -- why not stay in the roth 401(k)

Post by Engineer250 » Mon Jun 18, 2018 12:46 pm

My plan does not allow after-tax 401k dollars to get put into the Roth 401k; I think this would be called an in-plan conversion? It does allow an in-service withdrawal of just the after-tax portion.

Not sure if OP is misunderstanding after-tax vs Roth 401k.

I think getting as much into a Roth IRA would still be preferred over Roth 401k. After five years, contributions could still be withdrawn without penalties. I know a lot of financial independence buffs use the mega backdoor to fill up their Roth IRA and make early retirement more feasible. Also for me, the investment options in my 401k are not the best, so Roth IRA would be better.
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leftcoaster
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Re: mega backdoor Roth -- why not stay in the roth 401(k)

Post by leftcoaster » Mon Jun 18, 2018 7:21 pm

Yes, I mistakenly conflated Roth 401(k) and after-tax plan. My megacorp has both and also a regular 401(k).

What is the tax situation for funds left in the after-tax plan? It sounds like it's more similar to a non-deductible traditional IRA. I suppose the earnings would be taxed coming out if left there, just like a non-deductible IRA? And so the purpose of rolling to a Roth is to avoid that?

retiredjg
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Re: mega backdoor Roth -- why not stay in the roth 401(k)

Post by retiredjg » Mon Jun 18, 2018 7:54 pm

leftcoaster wrote:
Mon Jun 18, 2018 7:21 pm
What is the tax situation for funds left in the after-tax plan? It sounds like it's more similar to a non-deductible traditional IRA. I suppose the earnings would be taxed coming out if left there, just like a non-deductible IRA? And so the purpose of rolling to a Roth is to avoid that?
Yes. Leaving the money in the after-tax account for a long time is essentially the same as having an IRA filled with non-deductible contributions. It would be better for most people to have put the money into a taxable account instead.

The money is already taxed. Getting it into Roth means that (most of) the earnings will not be taxed. Leaving it in the after-tax account does not do that. The trouble is that all untaxed money coming out of an IRA is taxed at your ordinary tax rate. Some or all of this money would be taxed at the lower capital gains rates if the money had gone to taxable instead of the after-tax account.

The general feeling here is not to use an after-tax account if it cannot be rolled to Roth IRA or Roth 401k. However, one of our posters (the finance buff or tfb) has suggested that there is not much harm for shorter time periods. I believe he only looked at up to 5 years.

https://thefinancebuff.com/after-tax-40 ... ution.html

leftcoaster
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Re: mega backdoor Roth -- why not stay in the roth 401(k)

Post by leftcoaster » Mon Jun 18, 2018 8:28 pm

retiredjg wrote:
Mon Jun 18, 2018 7:54 pm

The general feeling here is not to use an after-tax account if it cannot be rolled to Roth IRA or Roth 401k. However, one of our posters (the finance buff or tfb) has suggested that there is not much harm for shorter time periods. I believe he only looked at up to 5 years.

https://thefinancebuff.com/after-tax-40 ... ution.html
Great -- I checked and my plan allows for an in-plan Roth conversion:
[*]An in-plan Roth conversion lets you convert non-Roth dollars in your account to Roth dollars, which are after-tax dollars. You pay taxes
on the amount you convert now, but you can receive the earnings on Roth dollars tax-free when you have a qualified distribution.
[*]The conversion is treated as a distribution for tax purposes and a rollover back into your account - even though your money never leaves the Plan.
So the advantage of doing this instead of rolling out to a Roth IRA is that I get the lower, institutional expense rate and also the ability to pull funds if I separate at age 55.

Am I missing anything ?

Lyrrad
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Re: mega backdoor Roth -- why not stay in the roth 401(k)

Post by Lyrrad » Mon Jun 18, 2018 9:38 pm

leftcoaster wrote:
Mon Jun 18, 2018 8:28 pm

So the advantage of doing this instead of rolling out to a Roth IRA is that I get the lower, institutional expense rate and also the ability to pull funds if I separate at age 55.

Am I missing anything ?
You also get the ability to roll it into another Roth 401k plan in the future. Roth IRA funds can't be rolled into a Roth 401k plan.

401k plan funds might be better protected from creditors compared with IRA funds, depending on the state.

My employer's plan allows for Mega backdoor Roth funds to be rolled out in service. It looks like not all employers offer this. My employer's plan allows any funds that were not elective contributions to the plan or employer contributions to be rolled out at any time.

retiredjg
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Re: mega backdoor Roth -- why not stay in the roth 401(k)

Post by retiredjg » Tue Jun 19, 2018 6:45 am

leftcoaster wrote:
Mon Jun 18, 2018 8:28 pm
So the advantage of doing this instead of rolling out to a Roth IRA is that I get...the ability to pull funds if I separate at age 55.
You largely have this ability anyway. The after-tax money rolled out to Roth does not have a 5 year clock on it. It does "sit behind" the money that was taxed at the time of the rollover though. That money does have a 5 year clock and is subject to 10% penalty if removed before the 5 year clock runs.

There are ways to work around this, but usually people don't seem to be too worried about it, I suppose because the amounts are small.

Keep in mind that the "age 55 withdrawal" only applies to plans that have that option. The law does allow it, but not all plans offer it.

There are a number of in depth old threads about the mega back door. You can find them using the google search box above.

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