Breaking down the Mega Backdoor Roth contribution

You may or may not have heard of a Mega Backdoor Roth, but they are becoming increasingly common, especially in the tech world. It is often confused with a Backdoor Roth IRA contribution (which is similar) or a Roth 401(k) contribution. It shares some similarities with both of those terms but is somewhat unique for a few reasons. 

Standard 401(k) Review

First, let’s review 401(k) contributions in general. Many of us are familiar with a 401(k) plan, sponsored by an employer, which allows you to defer up to $22,500 in 2023 (and a catch-up contribution of $7,500 if you are over 50). An employer may contribute a match on top of this, but employees are limited to the standard IRS annual limits. In a pre-tax 401(k), you are able to put your contribution into the plan and not pay any federal income tax on those contributions.

A relatively recent newcomer is the Roth 401(k)- added in 2006- which allows you to put money into your 401(k) on a post-tax basis. It doesn’t help reduce your taxable income now, but withdrawals in retirement are tax-free. The Roth 401(k) is subject to the same limits as a pre-tax 401(k); you can even do some of your contribution on a pre-tax basis and some as Roth.

So that’s the 401(k) structure most people are used to seeing at their jobs. The Mega Backdoor option allows you to save IN ADDITION to the normal limits. Say you’re already maxing out your regular 401(k) contributions at $22,500. The Mega Backdoor allows you to put additional money into the account on an after-tax basis (note: this is NOT the same thing as the Roth contribution). Then within the plan, you make an election for the contribution to be automatically converted to Roth. NOW you have funds in a Roth 401(k) which function like the Roth 401(k) contributions above (in other words, you do not pay taxes when the funds are withdrawn). 

Here’s an example. 

Let’s say you work at Microsoft, which was one of the first companies to offer this option. You’re maxing out your pre-tax 401(k) at $22,500 this year. Microsoft matches 50% of this for $11,250. You are now able to contribute another $32,250 to the after-tax 401(k)! This gets you to the annual IRS limit of $66,000 TOTAL contributions to your 401(k) account. That’s:

  • $22,500 pre-tax 401(k)
  • $11,250 employer match
  • $32,250 after-tax 401(k)

After you contribute the after-tax dollars, the plan allows for an automatic in-plan conversion to Roth. In the case of Microsoft they do this conversion daily, but in some cases it may be monthly or even quarterly. Note: the conversion itself may generate a small tax liability as you are required to pay tax on any growth from the time between contributing and the conversion itself.

And why does this help you?

There are a couple great things about this option. First, if you happen to make too much money to be eligible for a Roth IRA contribution, this is a great way to save money on a tax-free basis. Second, it greatly expands the amount you can save in a tax-advantaged manner. 

The Mega Backdoor Roth is the latest in a series of benefits that tech companies are offering to lure top talent. As mentioned, Microsoft has had this option for years, but Facebook, Google and Amazon have all jumped on the bandwagon in recent years. 

So if you have enough income to be able to afford to save that much to your 401(k), should you do it? The answer is quite likely yes, but there are certainly other factors to consider. In the case of Microsoft you also have the option to save into a Health Savings Account (HSA) or Employee Stock Purchase Plan (ESPP). Determining which of these to take advantage of can be a complex process. As with most things it’s wise to work with a financial planner who can help you determine if this is the right option for you, in light of your unique situation

Creating (or Revisiting) Estate Planning Documents During COVID

Estate planning is one of those topics that most people avoid at all costs. It ranks right up there with getting a root canal in terms of things to look forward to. I’m here to tell you that a) it’s really not that bad and b) the pandemic is a great reminder to review things you never thought you’d need (except in the worst case scenario, which looks an awful lot like present day).

First and foremost, I want to define what estate planning is. Much of the time, when I bring up the topic, a client says “Oh I don’t have enough money to worry about estate planning” or even “I don’t have any dependents so it doesn’t make any difference.” Both of these responses are based on a fundamental misunderstanding of the term estate planning. Essentially, it refers to a series of documents and directives that tell the world how you want your affairs managed; but the kicker is that many of these apply while you are still alive. In fact, the two documents I encourage all unmarried adults to get above all others is a health care power of attorney and a living will (aka medical directives).

Imagine you get in a car accident and are unconscious. You’re rushed to the hospital where they determine you need a life-saving (but risky) surgery to survive. Who gets to make the decision if you are unconscious? What happens next? If you are married, your spouse is able to make such a decision on your behalf. But what if your spouse is also in the accident and unable to perform this critical duty? You can see how easily things get complicated. And if you’re unmarried, it can be even worse. Can your parents make the decision? Does your partner have any say in the matter?

As unpleasant as you might think this topic is, I can assure you it is far more unpleasant dealing with an unexpected illness or death when documents have not been drawn up. I’m surely dating myself here, but if you remember the YEARS that Terry Schiavo was on life-support while her family battled about how to proceed, you’ll know how bad it can get when you haven’t clearly stated your wishes. I like to think of estate planning as a gift to your loved ones, which makes it easier for them in a time of extreme stress, to know what you would want.

I plan to write more on the topic in coming months, but a very quick overview of the types of documents you likely need and what they pertain to.

  • The will- most people are broadly familiar with what this document does. It tells people what happens to your assets if you pass away. This includes everything from your home to your bank account and even your pet(s). Perhaps most importantly for anyone with children, this is the document where you name a guardian for any minor children, should you and your spouse both pass away. If you do not have a guardian named, the courts will decide for you (this rarely leads to the best outcome). One important note here: 401(k), IRA and other retirement accounts as well as life insurance pass by beneficiary designation not through the will.
  • Powers of attorney (POAs)- as mentioned above, you may name an “agent” who can make health care and/or financial decisions on your behalf. You may have one person designated to be a health care POA and another person as your financial POA. 
  • Medical directives/living will- this is a document that states types of medical treatments or interventions that you do/do not want. For instance, a common one is to say you do not want to be placed on life support.

The current global pandemic is a very timely reminder to confirm that you have some of these basic documents in place. If you’ve already completed some or all of the above, how long has it been since you reviewed them? If your health care POA has since moved to Australia, they probably need to be replaced with someone local (if possible). I also recommend reviewing beneficiary designations periodically to ensure they still align with your wishes. 

My goal with this topic is for all of us to start to have these conversations and normalize the process. While talking about worst-case scenarios can be a bit morbid, the sense of relief you get once you’ve gotten these things in place is hard to quantify. My top takeaway for readers: if you have minor children get something in place for guardianship ASAP. You can always revise or fine-tune later but this is one you don’t want to wait on. If you are single (or not!), I strongly recommend getting a health care POA/living will in place. Don’t let the perfect be the enemy of the good. You’ll sleep better at night knowing you’ve made a step in the right direction. 

Xena Financial Planning is Born!

Xena Financial Planning blog introduction

Welcome to Xena Financial Planning (Xena FP).

I am so very glad you are here! Allow me to introduce you to my new firm.

I honestly did not set out with the intention of creating my own practice. In 2014, when I first entered the industry, I was eager to learn from more seasoned planners and get as much experience as possible. Fast forward 6 years and I feel called and emboldened to offer a new kind of planning firm.

My focus is on women (and their partners) in the early to middle stages of their careers. Specifically, I absolutely love helping clients who receive equity compensation as part of their income. It’s extremely common in the tech world and while there are plenty of brilliant people working in tech, many of them do not have the time or inclination to manage the influx of stock. I also offer a unique perspective and advice for women who own small businesses, based on many years of working in finance for small businesses and start-ups.

Not only do I feel compelled to serve a more specific demographic, I can improve on the process, which is in dire need of a facelift. The world of financial planning is in the midst of a seismic shift; the way that advice is delivered is dramatically different from the way prior generations received it. 

What I love about financial planning is the relationships and the process. I’m not overly focused on investment performance, nor do I plan to deliver a massive financial plan which might be better used as a doorstop. In my view, financial planning is a highly dynamic process, with many moving pieces that are constantly in flux. At Xena FP, I work with my clients on an ongoing basis, to help them navigate whatever life delivers. I strive to both educate and empower clients as we develop a collaborative relationship.

My desire to specialize, as well as build a process that works for our highly volatile world, led me to found Xena Financial Planning. Largely based on the fact that I founded the business in the midst of a global pandemic, my intention is to be 100% virtual. One of the things I have loved about the pandemic is not having to spend a lot of time in traffic; I am sure my clients can appreciate that! I’m so happy to have you here for some part of the journey. Together, we will build something extraordinary.

How much emergency reserve do I really need?

Xena Financial Planning blog rainy day fund

The conventional wisdom for an emergency reserve is about 3 to 6 months of living expenses, typically kept in a liquid, FDIC-insured account. So just how do you calculate “living expenses” and what exactly is “essential”?

In the current global pandemic environment, most of us have noticed a shift in our spending. Travel budget: $0, eating out: minimal. Your spending now is probably fairly representative of the minimum needed to survive. Things like your rent/mortgage, basic transportation expenses, food & utilities should absolutely be included. Now take that minimum monthly number and multiply it by 3. This is the smallest number you should target for an emergency reserve.

If anyone in your household is self-employed or has variable income (i.e. a real-estate agent, or an artist), you will want to target the higher end of the 3-6 month range. COVID and its effects have hit certain industries particularly hard. Even professional athletes are facing a significant cut to their expected income. Given the circumstances, it’s understandable to lean towards caution and keep as much as you can.

That’s a reasonable strategy for the short term, but don’t sacrifice saving for retirement or other goals in favor of sitting on oodles of cash.

On the flip side, if you’re just starting to save, these amounts may seem daunting. At the very least, aim to have a couple thousand dollars set aside in the event you have a major house repair or other unexpected expense. It won’t get you too far but it’s a great start. Plan to set aside a little bit from each paycheck until you reach the goal.

One of the benefits of working with a financial planner is that they can help you prioritize saving for an emergency reserve, paying down debt and saving for other short and long-term goals. All of the recommendations here are simply that.