Tax-free. These are two extremely desirable words when it comes to investing. No one likes paying taxes, but unfortunately, not many investment vehicles provide tax-free opportunities. That means you want to carefully explore all available options and take advantage of them when appropriate.
Vehicles such as health savings accounts (HSAs), Roth IRAs, and backdoor Roth IRAs provide such opportunities. Additionally, these vehicles have fairly low contribution limits. However, before opening such accounts, certain requirements must be met, eliminating many from taking advantage of them. It should be noted that a Roth account is the most common of these opportunities, with ~26% of U.S. households owning one. The issue is that many households can’t contribute to a Roth IRA due to income barriers.
There is another type of tax-free vehicle that is very underutilized, called the mega backdoor Roth 401(k) (offered by some 403(b) plans as well). This strategy allows you to save considerably more tax-free dollars.
So you might be asking: Why isn’t everyone taking advantage of the mega backdoor Roth? There are numerous reasons, but the concerns ultimately boil down to cash flow and a lack of awareness. You should consider this strategy only after establishing a solid cash reserve and maxing out your 401(k), which is not an easy feat. The purpose of this post is to explain what this strategy is and who it’s best suited for.
Understanding Eligibility and Contribution Limits
I will start by saying that, as of this writing, only ~15% of employers offer this strategy, primarily larger corporations. The good news is that this percentage has steadily increased over the years and is likely to continue growing.
Generally speaking, this strategy is best for high-income earners with excess cash flow who are already maxing out their pre-tax 401(k) contributions. As a reminder, the maximum pre-tax or Roth deferral limits for 2025 are:
$23,500: For those under 50
$31,000 ($23,500 + $7,500 catch-up): For those 50 to 59
$34,750 ($23,500 + $11,250 catch-up): For those 60 to 63
$31,000 ($23,500 + $7,500 catch-up): For those 64 and above
It is important to remember that you do not have to wait until you turn 50 to start catch-up contributions. They can commence in January of the year you turn 50.
Now, this is where the magic happens: Some retirement plans allow employees to make additional after-tax contributions above the yearly deferral limits and convert those funds to a Roth. The 2025 maximum limit for all sources is $70,000, which includes deferrals, employer matching, and profit-sharing contributions, allowing for a considerable amount to be allocated to this strategy.
To find out whether this is an option for you, you will want to refer to your employer’s Summary Plan Description (SPD), which you can obtain online or by asking your plan administrator. The SPD will help you understand your 401 (k)’s specific features and restrictions.
How the Mega Backdoor Roth Works in Practice
Generally speaking, the entire process works as follows:
An employee makes after-tax contributions to their 401(k).
The after-tax contributions immediately convert in-plan to the Roth 401(k) and grow tax-free.
The beauty of this process is that after-tax contributions are immediately converted to the Roth each pay period, so you owe no tax on any subsequent earnings prior to conversion. This allows for the most efficient accumulation of tax-free assets. Let’s take a look at an example below:
Ben, age 45, makes $325K/year and has a considerable amount of disposable income. His 401(k) offers the mega backdoor Roth 401(k) option. Ben is currently maxing out his 401(k) ($23,500) and receives a 3% company match ($9,750). This means he can contribute an additional $36,750 ($70,000 - $23,500 - $9,750) after tax and convert the amount to his Roth 401(k). If Ben does this for 15 years (assuming no salary increases or adjustments for inflation) and earns an 8% return, he will amass ~$1.21 million on a total of $600,000 in after-tax contributions. The gains of ~$610K would be completely tax-free for the rest of his life!
Source: Investor.gov.
It is worth noting that some 401(k) plans limit in-plan Roth conversions to a set number per year or over a specified period (e.g., once every quarter). In these cases, any earnings made on the after-tax contributions, which should be negligible, can be rolled to an outside IRA to avoid paying income tax in that calendar year. As mentioned, the Summary Plan Description is pivotal, as it lays out the specific rules for your plan.
Why Tax-Free Retirement Income Matters More Than You Might Think
So why is building tax-free dollars so important for retirement? Besides the obvious benefit of being tax-free, there are no required minimum distributions (RMDs)to take, it can help avoid Medicare surcharges (aka IRMAA), and it allows the funds to be inherited tax-free. In addition, having a large tax-free bucket may enable you to more effectively explore Roth conversions and the 0% capital gains tax bracket.
While having a large sum saved is a general recipe for a successful retirement, what’s often overlooked are taxes, meaning how much of your money you get to keep. Far too often, people assume they will be in a lower tax bracket throughout their retirement, which isn’t necessarily the case. In fact, we often come across situations where households must project being in a higher tax bracket for an extended period of their retirement. This is where exploring the various tax-free options comes into play.
The Power of a Systematic Approach and Professional Guidance
The most important takeaway here is to establish a systematic savings plan. Whether to a 401(k), traditional IRA, or a Roth, saving is of utmost importance. The sooner you start, the better.
Bottom line, the mega backdoor Roth 401(k) conversion strategy can be a powerful long-term tax-free savings vehicle for retirement. When utilizing this program, working closely with a financial advisor and tax professional can help ensure the process is handled properly from the start.
Discuss your situation with a fee-only financial advisor.
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