Enter the workplace Roth 401k account, first introduced in 2006. These accounts allow for potentially bigger contributions than traditional Roth accounts (which are limited to $7K/person/year except for 50+ which allows $8K total) and participants are not excluded based on their income level.  401(k) contributions in employer accounts offer a much higher employee contribution limit ($23K/person/year and $30.5K for 50+) and can be much higher with the addition of employer matching contributions.  A downside, however, was that, until recently, they required age-based distributions (a.k.a RMDs) unlike Roth IRAs which can be left untouched and passed along to heirs tax free.

The Mega Backdoor Roth is a popular retirement savings strategy that was conceived to use workplace After-Tax Accounts in a way that benefits high earners. Not its own account, it is a strategy that has specific steps to follow.

Who might benefit from a Mega Backdoor Roth?

This strategy is only relevant to the subset of savers with cash to save beyond the annual limits designated for workplace retirement accounts ($23,000 in 2024 or $30,500 for those 50+).  It is appealing as it could confer significant tax advantages down the road.  Though the number of clients for whom such a strategy is both available and achievable may be limited, we feel it is a topic worth raising.  At least being aware if such a strategy is available to you via your employer’s retirement plan creates a starting point for a planning analysis.

To maximize the strategy, you would key off the so-called 415(c) limit which is the maximum amount from ALL sources (includes employer match) that can be contributed to a workplace retirement account.  In 2024, that amount is $69,000 (or $76,500 for those 50+).  For example, for a 30-year old single filer earning $175,000 who has deferred $23,500 in earnings and has a 5% employer match (additional $8,750), as much as [$69,000-$23,000-$8,750] = $37,250 in additional monies could be contributed after-tax to the workplace After-Tax Account – thus the label “mega” – then rolled into a Roth account.

How does this work and why is it important?

Some logistics are set forth below (caveat:  the strategy requires some extra effort).  The benefits, however, are potentially significant as employees can pay taxes today on “excess” income and then forever shelter the growth in that income from any additional taxes while also removing the requirement to take the money out in retirement.  Since most of us contribute to traditional retirement accounts specifically for the purpose of lowering taxes today and withdrawing in retirement when our individual tax brackets may be lower, it becomes clear that this strategy is definitely not for everyone.  But for those that might benefit, read on!

Requirements for a Mega Back Door Roth:

• Does your employer’s retirement plan allow for after-tax contributions? (Estimates are that at least 50% of employer accounts allow this)
• Does the plan provide for “in-service” withdrawals? (This allows you to remove contributions from the plan while you are still employed).
• Are pre-tax and after-tax contributions tracked separately? (That is, are they tracked in separate “accounts”?)
• Has your employer passed “discrimination” testing? (Employers are limited by “fairness tests” in determining amounts that employees may be able to save after tax – consult with the plan sponsor and or Human Resources to be certain they can pass these tests (sometimes they may only know later in the year at which time your additional contributions MAY need to be returned to you).

If all of the above are “yes”, you may make after-tax contributions (after maximizing your regular contributions) and then take a distribution as soon as possible from the After-Tax Account and roll it over to either the workplace Roth 401k or to your Roth IRA. While rolling to a Roth IRA has been historically better due to restrictions in a Roth 401k, the accounts now seem to be on a more level playing field. However, for both, timing is important to minimize taxes that would be due for earnings that accrued in the account.

The Bottom Line

Because it is a rollover, you are not subject to income limitations that affect contributions to Roth IRAs, and then you have effectively (through the back door) created a Roth IRA that would otherwise not be available to you.

Because of the importance of tax brackets and disposable income to determining the efficacy of this strategy, plan to have a discussion with your accountant and EnvestAM advisor before committing to this path. For those fortunate enough to meet all the criterion, it is a great way to shelter income-producing assets from any additional taxes.