It's no secret that individuals should always consider and explore the most tax-efficient ways to save for their given circumstances. With taxes potentially set to increase, there is heightened awareness around some of the more nuanced ways to save efficiently. One strategy has been grabbing headlines, with the nomenclature like that of a fabled creature: The "Mega-Backdoor Roth IRA." The Wall Street Journal highlighted this strategy in a recent article, which was so widely circulated that even a handful of clients wondered if it was something they could utilize. So, I thought I'd offer a few insights.
Though well-written, in my opinion, the article paints a potentially misleading picture of an easy-can't-miss-always-effective strategy. In practice, it's an intricate and multifaceted process that won't work for everyone. It spurred the memory of a quote from one of my favorite movies, Batman Begins: "It's not that simple, with the Joker, it never is."
Those attempting intricate savings maneuvers, such as a "Mega-Backdoor Roth IRA," fortunately do not need to outwit the Joker to save Gotham City. But to save with this strategy, they need to comply with IRS, ERISA, and DOL regulations. Not analogize regulation with the Joker, but they can be an equally complex challenge.
I won't cover all of the details of the strategy, which you can read in the WSJ's piece. Essentially, you make an after-tax contribution (taxable, non-Roth) in your 401(k), convert that portion to Roth, and then roll that portion out to your Roth IRA. This technique is valuable because there are no income limits for this Roth contribution, and the amount you can contribute may be much higher than the standard IRA limits. However, I wanted to share some further considerations of the Mega Back-Door Roth IRA.
The strategy can be highly effective, but I don't want anyone to get their hopes up just yet. Please note, this approach involves several moving parts, and the information below is for educational purposes only. The inherent tax implications are specific to each individual, and any specific questions must be directed to the individual's tax specialist. As mentioned, quite a bit of nuance exists with this strategy, and the success rate is dependent on multiple variables. For the strategy to even be possible, you must first take the following steps and have the following available to you in your 401(k) plan design:
- Maximize your annual payroll 401(k) deductions (402g limit)
- Still be below the maximum 401(k) limit after employer matching/profit share (415c limit)
- Plan must allow for After-tax contributions
- Allow for Roth In-Plan Conversions
- Allow for Under 59 ½ In-Service Withdrawals (All plans must allow if over age 59 ½)
- Plan Passes Testing ACP & ADP Testing
These are just the requirements that the plan must meet on paper before the Mega Back-Door Roth is possible. Other hurdles and complexities to this strategy may arise over time, like taxes on gains of after-tax contributions and potential failed testing. In summary, when the rules are in place and your finances allow for this amount of saving, it can be a home run. Is it a strategy available to you? Perhaps.