Some of the best tax savings come from tax loopholes. One of the best tax loopholes is the Mega Backdoor Roth (MBR).
If you're eligible for the MBR, you have the opportunity to stuff tens of thousands of dollars into a tax-free Roth account without triggering extra taxes.
This post will cover who should consider the MBR, how it works, and the requirements for executing it.
Who Should Consider the Mega Backdoor Roth?
The MBR isn't as mainstream as the backdoor Roth IRA because fewer people have the disposable income and circumstances to capitalize on it.
It works best for investors who:
Are in a high tax bracket
Have healthy cash reserves
Max out retirement accounts
Have flexibility in a taxable brokerage
Want to save thousands in future taxes
It can be especially useful for those who got a late start on saving for retirement.
How Does the Mega Backdoor Roth Work?
In 2024, the maximum employee contribution to a pre-tax or Roth 401(k) is $23,000 ($30,500 if age 50+).
The maximum combined contribution between employee and employer is $69,000 ($76,500 if age 50+).
So, if your employer contributes $7,000, what do you do with the rest?
You make after-tax 401(k) contributions, then convert/transfer them to your Roth 401(k) or Roth IRA.
Today's tax liability is the same because you already paid tax on the after-tax contributions, so the conversion isn't taxable.
However, by converting the after-tax contributions to your Roth account, all the growth and future qualified withdrawals are completely tax-free.
I know it's exciting, but before you do anything, you need to know if your plan allows the MBR and the logistics for executing it. The rest of this post will help you figure out both.
Mega Backdoor Roth Eligibility
First things first: Does your plan allow after-tax contributions?
You can find the answer in the "Contributions" section of your 401(k)'s Summary Plan Description (SPD).
If the answer is yes, keep going. If the answer is no, you can stop reading.
Next, you need to determine if you are eligible to make after-tax contributions. Many plans don't allow Highly Compensated Employees (HCEs) to make after-tax contributions because it would cause the plan to fail the Actual Contribution Percentage (ACP) test.
In 2024, a HCE is someone who either:
Owned more than 5% of the business at any time in the prior year; OR
Receives more than $155,000 in compensation and ranks in the top 20% of employees by compensation
Source: IRS
Many HCEs are made aware of this classification in advance, but you can check with your HR department to confirm.
Two notes:
There is no ACP test for a solo-401k
If your after-tax contributions cause the plan to fail the test, you'll receive a contribution refund (and cause headaches for a few people)
This IRS article provides more details on the tests.
When in doubt, ask your company's HR department, benefits team, or the plan administrator (i.e Fidelity, Schwab, or other company that runs the plan).
Facilitating Mega Backdoor Roth Conversions
If you're eligible to make after-tax contributions, you're well on your way to executing the MBR. However, we need to confirm a few more details.
Does your plan allow "In-plan Roth Conversions" or "In-service Distributions"?
In-plan conversions are easier and more efficient, but in-service distributions also work. I'll explain how both work in a second, but first...
Remember that after-tax contributions aren't taxed when converted to a Roth, but the growth on contributions is taxed as ordinary income.
That's why you want to convert contributions shortly after making them.
If your plan has in-plan conversions:
Convert after-tax contributions ASAP to minimize the amount of growth in the conversion. Some plans may even facilitate automatic conversions of after-tax contributions.
If your plan has in-service distributions AND subaccounts for pre/after-tax contributions/balances:
Roll over ONLY the after-tax subaccount to an outside Roth IRA. Again, try to minimize the taxable growth included in the rollover.
Alternatively, you could roll over the growth on after-tax contributions to a Traditional IRA to defer taxation. However, if growth is minimal, it may be worth it to roll over earnings to the Roth IRA.
If your plan has in-service distributions BUT DOESN'T separate pre/after-tax contributions/balances:
Any rollover or distribution is funded proportionately from your pre- and after-tax balances (pro-rata rule). You can still roll over the after-tax money to a Roth IRA and the pre-tax money to a Traditional IRA to defer taxation.
However, you'll need to roll over all pre-tax money, including pre-tax contributions and associated growth, which can often be the majority of your account.
Remember to consult your personal tax/financial professional as these decisions should be made in the context of your complete financial situation.
Conclusion
Utilizing the Mega Backdoor Roth can shave years off your journey to financial independence.
Take advantage of this unique opportunity when it's available and start building your tax-free nest egg.
If you can't use the MBR, you may be eligible for a Backdoor Roth IRA. Check out, Should You Use a Backdoor Roth IRA to learn more.
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