mega backdoor Roth 401k practical issues

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lazylarry
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mega backdoor Roth 401k practical issues

Post by lazylarry » Fri Sep 01, 2017 9:33 am

So my employer recently started allowing megabackdoor Roth 401ks. Essentially, I am able to contribute to after-tax 401k and am able to convert this to a Roth 401k. I can not convert to a Roth IRA. However, I am only allowed two conversions per year. My contributions to the after-tax 401k are basically bimonthly. And I have maxed out my 402g $18000 contributions for the year into a pre-tax 401k and a Roth 401k.

What I am wondering is some practical things:

1) If I convert the after tax 401k to the Roth 401k, I should not not be subject to pro-rata rule, correct, given that this is an in-plan conversion?

2) Would I pay taxes on the gains in the after-tax 401k?

3) Given that I can only make two conversions a year, what are recommendations for making conversions? I know it might depend on the answer to Q2.
If there are no taxes, I guess it doesn't matter when. But if there are taxes, should I make the conversions early in the year? Or perhaps "market time" a bit and wait till the market is down to convert, thus not paying taxing since I will have losses in my accounts? I don't think it matters too much but wanted to get other's thoughts who had actually done something like this.

Thanks,
Lazylarry
My profile: https://www.bogleheads.org/forum/memberlist.php?mode=viewprofile&u=86026 | Virtua lBogleheads® Blog: https://virtualbogleheads.wordpress.com/

ved
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Re: mega backdoor Roth 401k practical issues

Post by ved » Fri Sep 01, 2017 10:39 am

What pro-rata rule? You mean that you have traditional IRAs, and are wondering if that impacts the in-pan conversion of after-tax 401k to Roth 401k?
If so, then 401k and IRA are completely different things, and the pro-rata rule does not apply.

Yes - you would have to pay taxes on any gains, during the year you convert. But, how much are you planning to contribute to the after-tax? Let's say you plan to contribute $36k (gets you to the $54k limit of all 401k contributions & matches, and assuming the company is not matching anything).
Assuming 10% annual gains, That is gains are $3600 for the $18k you are converting (in reality, it will be much less than $3600, because you are not investing the full $36k at the beginning of the year).
Assuming you are in the 28% tax bracket, tax on this will come to $1000 per year (again, it will be less because you will probably not have the $3600 gains).

I will be looking at it like paying $1000 to put $39,600 into a Roth...depending on your age, you can easily make up the $1000 in (tax-free) growth over the years.

I would not stress too much on the timing...I would do it at around June and December - just to keep things simple.

Ndop
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Re: mega backdoor Roth 401k practical issues

Post by Ndop » Fri Sep 01, 2017 11:11 am

Using's ved's example, you would pay $1000 in extra tax this year, but you also get another $2600 in your roth 401k.

Some have recommended putting your after tax money in a cash fund or other low income fund available within your 401k while waiting to convert to roth. But then you lose out on the $2600 gain. Also, what if your cash fund or low income fund still produced a tiny income? Then you still have tax forms to deal with. If you can afford the $1000 hit now, you'll likely be rewarded with much more later. Am I missing something?

ved
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Re: mega backdoor Roth 401k practical issues

Post by ved » Fri Sep 01, 2017 1:06 pm

You not only get the $2600 (actually, $3600, because you have to pay taxes from outside funds) into the Roth, but also the $36k into the roth - and let it grow tax free from now on. That's a powerful incentive.

Continuing that example, let's say now we have $40k after year 1 in the Roth from this after-tax conversion (rounding up the 36k contributions + 3.6k gains). And let's say the OP has 20 years until retirement/need to withdraw these funds. Assuming an annual 8% growth, we are looking at this $40 k to grow to $186k. That is, a gain of $146k - tax free.

If he had left it in the after-tax account, then this $146k would be taxed as ordinary income. If he had instead not contributed to after-tax, but invested in a taxable account, then he would pay tax at LTCG & qualified dividends rate. Either of these is a worse alternative than converting to Roth.

That is the power of Roth, if you have time, and the market behaves.

Alan S.
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Re: mega backdoor Roth 401k practical issues

Post by Alan S. » Fri Sep 01, 2017 2:33 pm

Be sure that the IRR is requested very clearly. Although an IRR can include the pre tax dollars in the 401k account as well as the after tax sub account, you will NOT normally want the IRR to include any of the pre tax portion of the account. Therefore, the request should be clearly limited to the rollover of the after tax sub account balance ONLY.

If you have a ton of deductions in a certain year, and therefore an opportunity to do an IRR from the pre tax portion of the plan as well as the after tax sub account, do NOT attempt to combine them or you could face pro rating on the entire plan. Rather, you would do the after tax IRR separately and on a different date do another IRR on the pre tax balance you are willing to pay taxes on. Request these very carefully because you cannot recharacterize if you get blindsided with a 1099R showing an unexpected taxable amount or realize you made an error long before the 1099R is issued. Your taxable amount is NOT determined at year like a TIRA conversion using the year end balance on Form 8606. Instead, each separate IRR is taxed based on the composition of the amounts you convert in that particular IRR with the appropriate pro rating.

The after tax sub account balance is normally distributable while still employed and that character is retained in the Roth 401k after the IRR. These amounts are referred to as ODAs (otherwise distributable amounts), because you can still take a distribution of them from your designated Roth. Conversely, if you do an IRR of elective deferrals and earnings that are NOT eligible for distribution, these are tracked as ONAs (otherwise non distributable amounts). The plan must set up separate accounting within the Roth 401k to track the ODA and ONA money and their earnings. This may be one of the reasons that some plans including the TSP have been slow to adopt IRRs.

The current trend for many plans is pull back on after tax to Roth IRA rollovers when they adopt IRRs. Like this particular plan, your after tax rollover must be via IRR and the plan gets to retain the assets. But if your plan still offers you a choice, the Roth IRA is usually a much better destination.

Ndop
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Re: mega backdoor Roth 401k practical issues

Post by Ndop » Fri Sep 01, 2017 3:59 pm

Ved, thanks for the correction about $3600 more going into the Roth, not $2600. Even more reason to not use a low income fund to park the after tax money until Roth conversion.

JBTX
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Re: mega backdoor Roth 401k practical issues

Post by JBTX » Fri Sep 01, 2017 4:27 pm

lazylarry wrote:
Fri Sep 01, 2017 9:33 am
So my employer recently started allowing megabackdoor Roth 401ks. Essentially, I am able to contribute to after-tax 401k and am able to convert this to a Roth 401k. I can not convert to a Roth IRA. However, I am only allowed two conversions per year. My contributions to the after-tax 401k are basically bimonthly. And I have maxed out my 402g $18000 contributions for the year into a pre-tax 401k and a Roth 401k.

What I am wondering is some practical things:

1) If I convert the after tax 401k to the Roth 401k, I should not not be subject to pro-rata rule, correct, given that this is an in-plan conversion?

2) Would I pay taxes on the gains in the after-tax 401k?

3) Given that I can only make two conversions a year, what are recommendations for making conversions? I know it might depend on the answer to Q2.
If there are no taxes, I guess it doesn't matter when. But if there are taxes, should I make the conversions early in the year? Or perhaps "market time" a bit and wait till the market is down to convert, thus not paying taxing since I will have losses in my accounts? I don't think it matters too much but wanted to get other's thoughts who had actually done something like this.

Thanks,
Lazylarry

I am confused. So you are able to contribute $18k to a traditional 401k, then contribute additional amounts to after tax 401k and roll it into a Roth 401k? Not to mention contributions to a 402 which I am not familiar with.

I a curious how you can contribute more than $18k to tax deferred 401ks. I thought that was a no no. I am probably misunderstanding something.

terran
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Re: mega backdoor Roth 401k practical issues

Post by terran » Fri Sep 01, 2017 9:51 pm

JBTX wrote:
Fri Sep 01, 2017 4:27 pm
I am confused. So you are able to contribute $18k to a traditional 401k, then contribute additional amounts to after tax 401k and roll it into a Roth 401k? Not to mention contributions to a 402 which I am not familiar with.

I a curious how you can contribute more than $18k to tax deferred 401ks. I thought that was a no no. I am probably misunderstanding something.
Here's what the OP is talking about: http://www.madfientist.com/after-tax-contributions/

Basically some plans allow the combination of 1) after tax (not roth) deferrals which is similar to contributing to a non deductible traditional IRA (so not very useful) and 2) in plan rollovers of those aftertax deferrals to a roth account while still working. This makes it similar to contributing to a roth through the backdoor (non deductible traditional IRA converted to a roth IRA), but which much higher limits and without the pro-rata conversion issues if you has existing traditional IRA balances.

JBTX
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Re: mega backdoor Roth 401k practical issues

Post by JBTX » Fri Sep 01, 2017 10:02 pm

terran wrote:
Fri Sep 01, 2017 9:51 pm
JBTX wrote:
Fri Sep 01, 2017 4:27 pm
I am confused. So you are able to contribute $18k to a traditional 401k, then contribute additional amounts to after tax 401k and roll it into a Roth 401k? Not to mention contributions to a 402 which I am not familiar with.

I a curious how you can contribute more than $18k to tax deferred 401ks. I thought that was a no no. I am probably misunderstanding something.
Here's what the OP is talking about: http://www.madfientist.com/after-tax-contributions/

Basically some plans allow the combination of 1) after tax (not roth) deferrals which is similar to contributing to a non deductible traditional IRA (so not very useful) and 2) in plan rollovers of those aftertax deferrals to a roth account while still working. This makes it similar to contributing to a roth through the backdoor (non deductible traditional IRA converted to a roth IRA), but which much higher limits and without the pro-rata conversion issues if you has existing traditional IRA balances.
Ok thanks. I had never even heard of a mega backdoor Roth before I got here. Still trying to get my arms around it.

I guess where I'm confused is the link talks about after tax traditional contributions rolling over to a Roth IRA. The OP specifically said his is not to an iRA, but to a Roth 401k. If that is right, how can he contribute $18K to a pretax 401k, and then additional money to a Roth 401k in the same year?
Essentially, I am able to contribute to after-tax 401k and am able to convert this to a Roth 401k. I can not convert to a Roth IRA
Sorry if I'm not getting it here...

lazylarry
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Re: mega backdoor Roth 401k practical issues

Post by lazylarry » Fri Sep 01, 2017 10:12 pm

Ah thanks all for helping.
Forgot pro rata doesn't apply to 401ks.
Will just simplify and invest in Jan (don't want additional taxes this year as I am at top of bracket)
What is IRR? Anyways I don't have to deal with this as conversions are very simple and clear in my plan and I plan to keep everything in 401k until I leave company.

Jbtx , I am contributing to a pretax 401k but converting after tax 401k to Roth 401k. Contribution limit 18 but can additionally convert up to 54k.
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Katietsu
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Re: mega backdoor Roth 401k practical issues

Post by Katietsu » Fri Sep 01, 2017 10:16 pm

The IRS limits on total 401k contributions is $53,000 in 2017. That means that you can contribute $18,000 pre-tax, and your employer typically contributes something.​ Some 401k plans then allow employees to contribute the remaining amount in after-tax contributions.

The plan might then allow you to move those after tax contributions to the Roth 401k as in the case of the OP. Some plans may instead allow you to move the after tax contributions out of the plan into an IRA as in the link.

terran
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Re: mega backdoor Roth 401k practical issues

Post by terran » Fri Sep 01, 2017 10:47 pm

JBTX wrote:
Fri Sep 01, 2017 10:02 pm
I guess where I'm confused is the link talks about after tax traditional contributions rolling over to a Roth IRA. The OP specifically said his is not to an iRA, but to a Roth 401k. If that is right, how can he contribute $18K to a pretax 401k, and then additional money to a Roth 401k in the same year?
Ah, right. There are a few ways this part can work. As the Madfientist link explains in the plan can allow in service withdrawals meaning you can remove the money from the plan (into a Roth IRA) while still working. The other option (as seems to be the case for the OP) is that the plan can allow rollovers within the plan from an after tax account to a roth account.

The $18k limit is set by section 402(g) of the code and would apply to the combined tax deferred and roth contributions made to the 401(k) by the employee so you're right that the OP could not make more than $18k of contributions between both pretax and roth. Section 415(c)(1)(A) further defines the overall limit of all contributions (employee deferrals/roth contributions, employer contributions and employee after tax contributions) to be $54k. So if the plan allows it, one can make additional contributions to an after tax portion of the plan under section 415(c)(1)(A) up to the total $54k combined maximum. Then, again if the plan allows it, you can either roll that after tax contribution out into an outside roth IRA, or roll it within the plan into a roth part of the plan

I know it all seems kind of silly and a roundabout way of getting to where you end up in the end, and that's because it is. None of this was really intended, it's just the result of complex laws that weren't fully thought out, so there are some funny loopholes that people have figured out ways to take advantage of. I'm not familiar with the details, but even the laws that make 401(k)'s possible really weren't meant to create something like the retirement account we now know as a 401(k). I think it was meant more as a set of laws for something more like a pension.

JBTX
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Re: mega backdoor Roth 401k practical issues

Post by JBTX » Fri Sep 01, 2017 11:28 pm

terran wrote:
Fri Sep 01, 2017 10:47 pm
JBTX wrote:
Fri Sep 01, 2017 10:02 pm
I guess where I'm confused is the link talks about after tax traditional contributions rolling over to a Roth IRA. The OP specifically said his is not to an iRA, but to a Roth 401k. If that is right, how can he contribute $18K to a pretax 401k, and then additional money to a Roth 401k in the same year?
Ah, right. There are a few ways this part can work. As the Madfientist link explains in the plan can allow in service withdrawals meaning you can remove the money from the plan (into a Roth IRA) while still working. The other option (as seems to be the case for the OP) is that the plan can allow rollovers within the plan from an after tax account to a roth account.

The $18k limit is set by section 402(g) of the code and would apply to the combined tax deferred and roth contributions made to the 401(k) by the employee so you're right that the OP could not make more than $18k of contributions between both pretax and roth. Section 415(c)(1)(A) further defines the overall limit of all contributions (employee deferrals/roth contributions, employer contributions and employee after tax contributions) to be $54k. So if the plan allows it, one can make additional contributions to an after tax portion of the plan under section 415(c)(1)(A) up to the total $54k combined maximum. Then, again if the plan allows it, you can either roll that after tax contribution out into an outside roth IRA, or roll it within the plan into a roth part of the plan

I know it all seems kind of silly and a roundabout way of getting to where you end up in the end, and that's because it is. None of this was really intended, it's just the result of complex laws that weren't fully thought out, so there are some funny loopholes that people have figured out ways to take advantage of. I'm not familiar with the details, but even the laws that make 401(k)'s possible really weren't meant to create something like the retirement account we now know as a 401(k). I think it was meant more as a set of laws for something more like a pension.
Wow. I had no idea this was even a possibility. Thanks for the explanation! The things I learn on this site are amazing!

schrute
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Re: mega backdoor Roth 401k practical issues

Post by schrute » Sun Mar 11, 2018 11:41 pm

lazylarry wrote:
Fri Sep 01, 2017 9:33 am
So my employer recently started allowing megabackdoor Roth 401ks. Essentially, I am able to contribute to after-tax 401k and am able to convert this to a Roth 401k. I can not convert to a Roth IRA. However, I am only allowed two conversions per year. My contributions to the after-tax 401k are basically bimonthly. And I have maxed out my 402g $18000 contributions for the year into a pre-tax 401k and a Roth 401k.

What I am wondering is some practical things:

1) If I convert the after tax 401k to the Roth 401k, I should not not be subject to pro-rata rule, correct, given that this is an in-plan conversion?

2) Would I pay taxes on the gains in the after-tax 401k?

3) Given that I can only make two conversions a year, what are recommendations for making conversions? I know it might depend on the answer to Q2.
If there are no taxes, I guess it doesn't matter when. But if there are taxes, should I make the conversions early in the year? Or perhaps "market time" a bit and wait till the market is down to convert, thus not paying taxing since I will have losses in my accounts? I don't think it matters too much but wanted to get other's thoughts who had actually done something like this.

Thanks,
Lazylarry
Very curious, where did you net out here? I'm looking to do the same.

lazylarry
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Re: mega backdoor Roth 401k practical issues

Post by lazylarry » Mon Mar 12, 2018 9:21 pm

schrute wrote:
Sun Mar 11, 2018 11:41 pm

Very curious, where did you net out here? I'm looking to do the same.
Actually ended up being a lot easier decision, as I just got sort of lazy about it. You do have to pay taxes on any gains during the time of conversion, taxed as ordinary income. I ended up converting about 8k with $300 gains (I think they just averaged gains since I didn't have an option to do specific lots). That was right around the time of mini-dip in the market, so it worked out nicely. However, in retrospect, I would have just converted earlier on. At the end of the day, the market will more likely climb so I think more time in market (e.g. not converting) means more taxes for you. This ends up being a decision that will likely be worth only a few hundred dollars at most, which is not much in the grand scheme of things.
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