What in the World is a “Mega Backdoor Roth Conversion” and How Does it Work?

By: Christopher L. Hudson, CIMA

A Mega Backdoor Roth Conversion is a strategy that allows investors to fund a Roth IRA account using the after-tax contributions within their company 401(k) plan and thus avoiding many of the “restrictions” that are placed on contributing to a Roth IRA (income limits, annual contribution limits, etc….). It is typically used by investors who exceed the income limit for making a Roth IRA contribution ($144,000 in 2022 for a single tax filer / $214,000 for a married couple filing a joint return) or who desire to put away more money than the annual contribution limit will allow ($6,000 for someone under the age of 50 / $7,000 for anyone 50 or older in 2022).

In order to take advantage of this strategy, the employee’s 401(k) plan must offer two things:

• The ability to take “In-Service Withdrawals” or the ability to transfer any after-tax contributions made to the company 401(k) plan into the Roth 401(k) offered by their employer: In-Service Withdrawals, also referred to as “In-Service Distributions” or “Option One Distributions” at some companies, allow employees to take withdrawals, or distributions, from their company plan while they are still working. The employee does not have to separate from service or transition from the company in order to take the distribution. To execute a Mega Backdoor Roth Conversion, the employee takes the after tax contributions they have made to the plan and immediately rolls those contributions over into a Roth IRA account utilizing the In-Service Withdrawal or “Option One distribution” available to them within their company plan. As long as only the after-tax contributions are being rolled over (meaning the rollover does not including any gains or growth earned on those contributions) there will be no upfront conversion taxes.
• The ability to make after-tax contributions to the plan. Most, but not all, companies allow employees to contribute money on an after tax basis (meaning it has already been taxed as earned income) after they have met the limit on pre-tax contributions into their company plan ($20,500 for someone under the age of 50 - $27,000 for an employee 50+ in 2022). These after-tax contributions, above and beyond the pre-tax limits, are the funds used to execute the Mega Backdoor Roth Conversion.

Keep in mind that there are overall limits on how much money (in total from all sources combined) an employee can contribute to a 401(k) plan in any given year. This year (2022), those amounts are $61,000 for someone under the age of 50 and $67,500 for someone age 50+. So the maximum amount of money that can be rolled over to fund a Roth IRA account this year is $40,500 if you are not receiving any company contributions (or match) which would reduce the amount by the dollar value of the company match received. As an example:

• “Employee A” is 47 years old (under the age of 50)
• She contributes the full $20,500 that she is able to on a pre-tax basis
• She receives no company matching funds

$61,000 Total contribution limit under the age of 50

-$20,500 Pre-tax contributions made by the employee

-$0 in company contributions / matching funds

$40,500 in additional after-tax contributions that could be made and converted

• Employee “A” is 47 years old (under the age of 50)
• She contributes the full $20,500 that she is able to on a pre-tax basis
• She receives a $6,000 matching contribution from her company

$61,000 Total contribution limit under the age 50

-$20,500 Pre-tax contributions by the employee

-$6,000 in company contributions / matching funds

$34,500 in additional after-tax contributions that could be made and converted

In both examples, the employee was able to fund a Roth IRA account with significantly more money than she would have been able to if she were simply making an annual contribution ($6,000 for anyone under the age of 50 in 2022). It is also possible that she could exceed the earnings limit for this year and would not be eligible to make a Roth contribution at all. How is able to put away so much money in our example? Because this is considered a “conversion” and not a “contribution” so she is able to avoid the restrictions surrounding Roth IRA contributions. The caveat is that she would have to be able to afford to make these additional contributions to her company plan and would not receive an immediate tax benefit for doing so. The long-term benefit would be that the withdrawals that she eventually takes from the Roth IRA would be federally tax free if she is at least 59 ½ and the money has been inside of the Roth IRA for at least 5 years from her first deposit (conversion).

Since we are talking about taxes, let’s go over some of the “rules of the road” for avoiding upfront conversion taxes.

• Only the after-tax contributions that are made to a company plan can be used to fund a Roth IRA account and avoid any upfront taxes.
• Many plans work on what is known as a “pro rata” basis meaning that you do not have the opportunity to choose if only the after tax contributions come out as part of your In-Service Distribution.
• Your In-Service Distribution could very well be made up of a combination of after-tax contributions, pre-tax contributions and/or gains and growth.
• In order to avoid tax consequences, it could make sense to roll any pre-tax contributions and any growth and/or gains into a traditional IRA when you complete your In-Service Distribution. The separate check, made-up of only the after tax contributions would then be deposited into the Roth IRA.
• Some plans do allow you to take only the after-tax contributions or make you take the after-tax contributions first before moving into pre-tax contributions and matching funds so it is imperative that you reach out to your company and have an understanding of exactly how the In-Service Distribution option works for your specific company as every company can be a little different.

The Mega Backdoor Roth Conversion can be a powerful tool in saving for retirement and offer many advantages. It is often an underutilized strategy simply because many investors are not aware of it and the potential long-term advantages it offers. It is always beneficial to know all of the options that are available to you as you plan for, save for and ultimately enter in to retirement. Starting with a comprehensive retirement financial and sitting down with a financial professional is a good way to “flush out” all of these options and begin to craft a customized strategy that meets your goals and objectives.

Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional. Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion.