Using the Mega Backdoor Roth Strategy to Unlock Maximum Retirement Savings Potential
Most people have a working knowledge of the annual limits employees can contribute to their employer-based retirement savings plan. But based on our conversations with clients, it’s clear one strategy is not as well known and could provide a significant boost to the high earners’ retirement savings pace, a strategy known as the Mega Backdoor Roth. In short, this approach goes beyond mere accumulation but provides ample opportunity to strategically enhance tax-free retirement savings, which over the long term, could lower what is often the biggest liability for retirees – taxes.
Navigating Contribution Limits for Optimal Growth
At first glance, retirement savings seem straightforward—contribute to your 401(k) or 403(b), receive your employer's match, and grow your savings tax-deferred. However, most people are familiar with the IRS caps, the limited amounts one can contribute directly into the pre-tax or Roth portion of the account. For 2024, that limit is $23,000, or $30,500 if you are over 50, including catch-up contributions. While these limits are generous, they may not be enough for those on the higher end of the earnings scale who seek to save more to accelerate and potentially pull forward the retirement date. Much less known is the fact that the total plan contribution limit for 2024 stands at a substantial $69,000 for individuals under 50, and $76,500 for those aged 50 or over.
Enter the Mega Backdoor Roth. If available in the employer plan, this strategy allows individuals to make after-tax contributions to their retirement plans, which can then be converted to a Roth 401(k) or Roth IRA—amplifying their tax-free cash flow in retirement.
This limit, known as the Defined Contribution Section 415(c) limit, is a combination of the employee elective deferral contributions ($23,000, or $30,500 if over 50), employer contributions, and after-tax non-Roth contributions.
Who should explore this strategy? If you are routinely hitting the $23,000 limit on elective deferrals, you are on the right track. However, opportunity for greater growth lies in leveraging the gap up to the $69,000 threshold, which is precisely where the advantage of the Mega Backdoor Roth becomes pivotal.
The Tax-Free Growth Advantage
While asset allocation is a well-known and prudent strategy for investing, tax diversification among your retirement savings options is an often-overlooked opportunity. Just as you would not invest solely in one stock, you should not rely on one type of tax treatment for retirement savings.
In charting your retirement savings strategy, consider the distinctive benefits of each contribution type:
- Pre-Tax Contributions: Typical of a Traditional 401(k), these contributions reduce your taxable income in the current year, offering immediate tax relief and higher after-tax cash flow. However, taxes are due withdrawals during retirement, when it is often assumed that your tax rate will be lower.
- Roth Contributions: While these do not lower your current taxable income the year of the contribution, they offer a trade-off: tax-free withdrawals in retirement. This can be particularly advantageous if you anticipate being in a similar or even higher tax bracket in retirement, anticipate an increase in future tax rates, or both.
- After-Tax Contributions: These are made with income that has already been taxed. The critical key of after-tax contributions, however, lies in their capacity for conversion of these after-tax funds to Roth status—ultimately “converting” to tax-free growth.
Each type plays a critical role in diversifying your tax exposure and maximizing growth. When effectively utilized, the Mega Backdoor Roth strategy harnesses after-tax contributions, transforming them into Roth savings and thereby unlocking the tax-free growth advantage.
Ideal Candidates and Common Misunderstandings
Who stands to benefit the most from this strategy? It's ideal for high earning professionals seeking to go beyond the typical retirement savings avenues. These are often individuals who:
- Earn high incomes, typically $250,000 or more.
- Are already maximizing the $23,000 annual contribution limit.
- Possess the financial flexibility and excess cash flow to invest beyond their immediate living expenses and primary savings goals, after maximizing contributions to other savings vehicles such as Health Savings Accounts (HSAs) while still meeting other goals for education savings plans, and personal brokerage investment accounts.
Still, some harbor misconceptions, with the most common being a misunderstanding about income limits and Roth contributions. In short, this thought process mistakes the Roth 401(k)'s flexibility with the income limitations of a Roth IRA. The truth is, there are no income limits for Roth 401(k) or after-tax non-Roth contributions, clearing the way for high earners to leverage this strategic opportunity.
How the Mega Backdoor Roth Works
Executing the Mega Backdoor Roth strategy involves three critical steps:
- Confirm Plan Eligibility: Ensure that your retirement plan allows for after-tax non-Roth contributions by reviewing a copy of your Plan Document or Summary Plan Description. Although most retirement plans offer a Roth feature, it is important to note that only about 22% of plans offer the option to make after-tax contributions (Source, Vanguard “How America Saves 2023”).
- Calculate Contribution Amount: Knowing the plan's contribution limits and how much the employee and employer will contribute to pre-tax, or Roth deferrals will guide you to the amount to further invest after-tax dollars.
- Plan for Conversion or Withdrawal: Confirm if the plan allows for in-plan Roth conversions or in-service withdrawals and chart out the conversion strategy. This is the key step where after tax contributions make their way from the after-tax “bucket” of money, into the Roth account. If your plan offers in-plan Roth conversions, you can directly convert your after-tax savings to Roth within the same plan, often the most straightforward method. In contrast, in-service withdrawals permit you to move funds out of the plan, typically to a Roth IRA, offering more control over investment choices but possibly involving more steps and complexity. Depending on your plan, these actions may be performed on an automated or manual process.
Caveats and Considerations
No financial strategy comes without fine print, so it is important to be aware of the intricacies of the strategy. For instance, if an employee made after-tax contributions in the past that have not been converted to a Roth 401(k) or Roth IRA and they have experienced growth, these earnings may be subject to taxation under the Pro Rata Rule during the conversion to a Roth IRA. This is critical to understand.
Furthermore, some plans may cap after-tax contributions, or not allow for in-plan Roth conversions or in-service withdrawals, requiring additional considerations.
Given these complexities, we always encourage people to work with their wealth advisor and tax specialist before undertaking a strategy like this.
Bottom Line
The Mega Backdoor Roth is more than an excess savings strategy; it is a potential pathway to greater financial flexibility in the form of a lower tax base in retirement, for those who are willing and able to contribute. By harnessing the power of after-tax contributions and strategic conversions, you can greatly accelerate your retirement timeline and reduce your tax burden in retirement.
If you are seeking tailored advice to maximize your retirement savings, we invite you to reach out to us to help determine if the Mega Backdoor Roth strategy is appropriate for your scenario. Integrating this strategy with the broader wealth plan (investing, tax, estate planning, cash flow) can help provide peace of mind of knowing what could be the most substantial cash outflow in retirement, taxes, has been effectively and efficiently minimized.