A mega backdoor Roth 401(k) is a good tool for high-income individuals to save more money for retirement and reduce future taxes. It is called a “backdoor” Roth 401(k) because it allows individuals to contribute above the 401(k) limit – which is $22,500 in 2023. Through a mega backdoor Roth 401(k) you can contribute up to $66,000 in 2023 if you’re under 50 years of age. There are some important considerations to keep in mind when using this strategy. This includes whether or not the plan includes automatic conversions. Learn if this strategy of using a mega backdoor Roth 401(k) is right for you.
What is a Mega backdoor Roth 401(k)
A mega backdoor Roth 401(k) is a way to contribute additional funds to a 401(k). It involves making after-tax contributions to your 401(k) through your employer. It is a useful tool for high earners who want to take advantage of tax-free growth and the withdrawal benefits of a Roth retirement account and have already maxed out the pre-tax maximum of their 401(k). Because the tax is paid prior to the contribution, any earnings are tax free. These tax savings can really add up the earlier you leverage this tax strategy in your career.
How Much Can You Contribute to a Mega Backdoor Roth 401(k)
Every year, the IRS sets the employee pre-tax and Roth 401(k) contribution limits. The maximum combined amount you and your employer can put into a 401(k) in 2023 is $66,000 for under age 50. For over age 50, the maximum is $73,500 in 2023.
Does Your Mega Backdoor Roth 401(k) Plan Offer Automatic Conversions
When signing up for the mega backdoor Roth 401(k) through your employer, it is important to understand if the plan supports automatic conversions. This means that once new contributions are made to your after-tax account they are immediately converted to your Roth account. Though the contributions have already been taxed, any earnings from the contributions haven’t been taxed. An automatic conversion can reduce your tax liability on each conversion. This is because it eliminates the time the incoming money would be accruing taxable earnings. If your company does not offer this, you may have to do it manually and it could result in higher taxes. Converting any earnings to a Roth will trigger a tax bill in the year of the conversion. So, if you have to do a manual conversion you’ll want to do it the same day the contribution is made.
When Can You Start Withdrawing From a Roth 401(k)
As of 2023, the earliest you can withdraw from your 401(k) is 59 ½ years old without incurring a penalty. There are some exceptions to this rule. You may be able to take penalty-free withdrawals of your contributions at any time, as long as you held the account for at least 5 years. You can also withdraw 401(k) earnings if you meet these exceptions:
- You become disabled
- The funds are used for certain qualified higher education expenses
- The funds are used to buy a first home (up to $10,000 lifetime limit)
- The funds are used to pay for unreimbursed medical expenses that are more than 7.5% of your adjusted gross income
- You use the funds to pay for health insurance premiums while you are receiving unemployment benefits
Laws do change, so it is always best to consult your accountant before you make any withdrawals of your Roth 401(k). These also are available for Roth 401(k) accounts and may not apply to other types of retirement accounts. If you do withdraw early, even following these exceptions, you will lose out on tax free future earnings.
Should You Contribute the Full Amount to a Mega Backdoor Roth 401(k)
Ultimately, how much you contribute to a Mega Backdoor Roth 401(k) depends on your situation. You may want to stay more liquid in your taxable accounts given the current economic uncertainty. Your 401(k) plan may not offer as many investment options as your Roth IRA. The tax savings now with a pre-tax 401(k) may also be more impactful than the tax savings realized 30 years from now. Or, you may have better investments available outside your 401(k) which outweigh any future tax savings. As you start earning more money though, your financial plans should be reassessed. It is a great time to consider to if the Mega Backdoor Roth 401(k) should be part of your retirement savings strategy.