Mega-backdoor Roth

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It is possible to fund a Roth account far in excess of normal contribution limits through a strategy known informally as the mega-backdoor Roth. This process is available only through select employer plans, and the rules for these plans may vary considerably from one company to another. The strategy involves two steps:


 * 1) Contributing to an after-tax 401(k) account, and
 * 2) Rolling the funds over to either a Roth IRA, or to a  Roth sub-account within the plan.

The net effect of the above is equivalent to contributing to a Roth account, but there are no income limits for either of the two steps, unlike for Roth IRA contributions. The biggest advantage of this strategy stems from the fact that the after-tax 401(k) account has different rules from traditional and Roth 401(k) accounts: it is subject to much higher contribution limits (up to $58,000 in 2021), leading to the "mega-backdoor" moniker.

Note that "mega-backdoor Roth" is an informal term; neither the IRS nor your company will officially recognize it, and tax preparers may not be familiar with it either. The term is just a colloquial phrase that investors use. So if you come across someone who has never heard of it, just use the terms "after-tax 401(k) contribution" (step 1), and "Roth conversion" (step 2) instead, because that's what is really happening. After-tax 401(k) contributions are different from, and should not be confused with, Roth 401(k) contributions.

Also note that there is a process called backdoor Roth that is completely different from the mega-backdoor Roth. They are independent of each other, and can both be performed in the same year.

The discussion below refers to generic IRS rules; consult your own company's documentation for specifics.

Advantages

 * Subject to much higher contribution limits than traditional 401(k)s (up to $57,000 in 2020, $58,000 in 2021)
 * If funds are rolled into a Roth IRA, or a Roth account within the 401k using an in-plan Roth rollover soon after contribution, gains (and tax on them) will be minimal. Further growth in the Roth IRA is tax free (subject to the usual Roth IRA restrictions).
 * Some 401(k)s allow for in-service distributions, allowing employees to roll over funds during employment without a triggering event.
 * Protection from creditors under ERISA.

Potential disadvantages

 * Death, for monies waiting for rollover, the inheritor is left with a non-deductible IRA with very complicated paperwork.
 * Losses before rollover, "basis" could be lost if you don't leave a few pennies in the account. Check with your plan to see how it handles this situation.
 * Additional paperwork: You may receive two 1099-R's every year, one for the rollover and one for the gains. As many accountants aren't aware of the documentation requirements, this increases the chance for error.
 * Company fails nondiscrimination tests, resulting in a return of contributions. See Highly compensated employee.

Determining if your plan supports the mega-backdoor Roth
The mega-backdoor Roth strategy is not supported by all 401(k) plans. The plan must offer both of the following features:
 * 1) After-tax contributions to the 401(k), and
 * 2) Roth conversions of after-tax contributions, either as an in-plan conversion or as an in-service distribution, as described below.

Note that "mega-backdoor Roth" is an unofficial term and unlikely to be recognized by your company; the bolded phrases above are what you should check for. Your 401(k) plan documentation, often referred to as a Summary Plan Description, contains the details for after-tax withdrawals or conversions and whether or not they're allowed. Specifically, if they are allowed without a "triggering event". Triggering events include job loss, retirement, or death, and are typical for many types of contracts.

The rules regarding Roth conversions of after-tax 401(k) contributions vary greatly between employer plans. Some allow for in-plan conversions into a Roth 401(k) account, while other plans allow a rollover into a Roth IRA account, which is referred to as an in-service distribution. If both options are offered, which one may be preferred is a personal choice, but below is some rationale for each approach.

The in-plan conversion to a Roth 401(k) may be preferred since it can minimize taxable earnings if an automatic conversion plan is offered; it may also be easier to set up.

Alternatively, a Roth IRA conversion may be preferred due to the greater variety of investment options it offers, as well as flexibility of withdrawals, since Roth IRA contributions (but not earnings) can be withdrawn without penalty.

Be sure to check for rules or restrictions that may surround withdrawals. Some potential examples include suspension of after-tax contributions, or matching contributions, for a specified timeframe after receiving the distribution; or requiring you contact Human Resources to resume making after-tax contributions to your plan.

Earnings on after-tax contributions
Earnings associated with after-tax contributions are pretax amounts. Distribution of these earnings is therefore taxable as ordinary income. Therefore it makes sense to perform the two steps in quick sequence. To facilitate this, some plans may also provide for automatic in-plan Roth conversions, which can be scheduled to occur immediately after the after-tax 401(k) contribution. Another option is to invest the after-tax contributions in a stable value fund, to minimize taxable earnings in the short period before performing step 2.

Alternatively, any earnings may be rolled over into a traditional IRA. Note, however, that this may cause pro-rata issues if the backdoor Roth is also being performed in the same year. Consider that the earnings may be so small that it makes more sense to do a direct rollover of the entire amount to your Roth IRA and pay taxes on the earnings.

If desired, the plan provider should provide the option to distribute the contributions and earnings separately (one check for earnings, one check for contributions). Each distribution can then be rolled over into a separate, appropriate account.

Some plan providers may not offer this choice (one check for both earnings and contributions). If this is the case, request a single check payable to yourself. The plan must withhold 20% of the earnings (the pre tax portion of the check), so your net check is a little less than the distribution. Then, do a 60 day rollover of the gross pretax amount (the earnings) to your traditional IRA. Do this first. Once complete, then roll the after tax amount (making up the withheld amount from your other funds) into your Roth IRA.

There is no tax on the distribution. Report it as a rollover on Form 1040 lines 16a and 16b just like you would a direct rollover. Remember to claim credit for the withholding that will show on the 1099-R.

The backdoor and mega-backdoor Roths
The mega-backdoor Roth should not be confused with the backdoor Roth, a similarly titled but entirely different technique that also allows you to fund a Roth account in excess of income-based contribution limits. As can be guessed by the name, the mega-backdoor Roth allows you to contribute more than the backdoor Roth (up to $58,000 vs. $6,000, per 2021 IRS limits).

However, this doesn't mean you should do only one or the other. As the following table shows, they are independent strategies that can be executed in the same year. They both involve two steps: contribution and conversion, but use a completely different set of accounts. Be sure to thoroughly read the corresponding articles and IRS documentation before attempting either, as mistakes may be time-consuming and costly to rectify.

Note that there is one special situation in which the two processes can interfere, described in the previous section, that occurs when rolling over after-tax earnings to an IRA. This can be resolved using any of the methods described in the backdoor Roth article, such as rolling the IRA earnings over to a 401(k).