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 $19,500 in 2020 (and a catch-up contribution of $6,500 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 $19,500. 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401(k) which function like the Roth 401(k) contributions above (in other words, you do not pay taxes when the funds are withdrawn).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 $19,500 this year. Microsoft matches 50% of this for $9,750. You are now able to contribute another $27,750 to the after-tax 401(k)! This gets you to the annual IRS limit of $57,000 TOTAL contributions to your 401(k) account. That’s:
- $19,500 pre-tax 401(k)
- $9,750 employer match
- $27,750 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.