Instructing my youngest son to
simply “go clean his room” creates all sorts of problems. First, there is
a gap in definitions. His version of clean and my version of clean are worlds
apart. Parents, start nodding if not already. Cleaning his room
generally requires parental assessment of the current situation to map out a
plan of attack. At this point, even if he is given clear and explicit
instructions like “put all the games away”, there’s an implementation
problem. Putting the games away for him might mean simply shoving
everything under his bed or could take the more creative approach of hiding the
Monopoly pieces into his laundry bin so they’re “put away”. Finally,
there’s the maintenance problem of keeping things clean so that clean now
equals clean in an hour from now.
The reality is that these challenges
arise all the time in financial planning. Generic advice, even if sound,
rarely ever should be blindly applied. Each situation is unique and it can be
challenging to know whether “go clean your room” instructions even
makes sense in your unique situation. Furthermore, implementation poses a
challenge given the subtleties of each unique situation.
As an example, consider the “mega backdoor Roth contribution” strategy.
What is the mega backdoor Roth
contribution strategy?
You may have heard of the backdoor Roth contribution –
an increasingly popular tax-saving strategy over the past decade since a 2010
tax law change. The backdoor Roth contribution lets some high income earners
contribute $6,000 – $7,000 each year to a tax-free Roth account. The mega
backdoor Roth contribution is a distant cousin that lets high income earners
contribute as much as $37,000 each year to a tax-free Roth account.
Most employees who are eligible to
contribute to a 401k plan are limited to annual contributions of $19,000 or
$25,000 for individuals age 50 and over (2019 limits). These elective
employee deferrals can be either traditional pre-tax contributions or they are
Roth post-tax contributions.
Beyond these employee contributions,
there may be an employer match or employer profit sharing. The IRS sets
another limit on the aggregate amount of annual contributions – what gets
referred to as the 415 limit (defined in Section 415(c)(1)(A) in the IRS tax
code). In 2019, the 415 limit on all contributions to a 401k plan is
$56,000 for employees under 50 and $62,000 for employees age 50 and over.
That means there is $37,000 of space
between Roth/traditional 401k deferrals and the aggregate 415 limit ($56,000
minus $19,000 or $62,000 minus $25,000). Some or all of this $37,000 may
be filled by employer contributions. To the extent it is not filled,
employees can be permitted to make after-tax 401k contributions to absorb
whatever remains of the 415 limit. And this is where the mega-backdoor
Roth contribution strategy begins – with employees making after-tax
contributions, beyond their elective deferral limits of $19,000/$25,000, to
their employer’s 401k plan.
Let’s pause here because there is
the potential for confusion. After-tax 401k contributions are not the same
as Roth 401k contributions. Both are made with post-tax dollars but Roth
401k contributions are subject to the elective deferral limit of $19,000 (or
$25,000) whereas non-Roth, after-tax contributions are simply subject to the
415 limits ($56,000 or $62,000). Moreover – and this will be really
important as we explain things further down – the growth on any after-tax 401k
contributions is subject to taxation as ordinary income when distributed.
Alternatively, any growth on Roth 401k dollars is tax-free.
Should I make mega backdoor
Roth contributions?
There is plenty of written personal
finance advice effectively saying “The mega backdoor Roth contribution is a
great idea – you should do it.” Standard, boilerplate advice that equates
to me telling my son to go clean his room. Except that he may not need to
clean his room. Or his big brother locked the door so that he can’t clean
his room. Or cleaning his room without first evaluating what needs to be
cleaned will cause more harm than good. All of those concepts apply here
in relation to determining whether you should make mega backdoor Roth
contributions.
A mega backdoor Roth contribution
can be extremely useful for some people and terribly counterproductive for
others – resulting in more taxes (and fees), rather than less. The first
step is to assess whether you’re eligible for mega backdoor Roth contributions
and whether such contributions ought to be considered. All, not just some,
of the following conditions must be met for the mega backdoor Roth to be a
worthwhile strategy:
- Your employer must permit after-tax retirement plan contributions beyond the elective deferrals. That is to say that employers do not have to permit these contributions – and many do not.
- You must have the capacity and/or desire to save more than the elective deferral limits of $19,000/$25,000. If you are a high income earner looking to save extra dollars in a more tax-friendly way, check this box.
- Your 401k plan needs to provide reasonably good investment options without high investment and/or administrative fees. If the plan lacks low-cost investment options, the math on after-tax 401k contributions works against you, not for you. (Notably, this factor doesn’t apply if your plan permits periodic in-service distributions that gives you the ability to entirely remove funds from the plan as explained in #5 below).
- If you work for a generous employer, there must be room to make after-tax contributions under the 415 limit without cannibalizing employer contributions. Consider the example of a large, Atlanta-based airline that provides substantial employer contributions to its pilots such that many pilots hit the 415 limits each year just by way of employer contributions or with traditional/Roth 401k deferrals plus the employer contribution. In such cases, a pilot making after-tax 401k contributions actually reduces the “free money” he/she receives from the employer because the total contributions cannot exceed $56,000 (or $62,000). In an extreme example where a 45-year old pilot defers $19,000 to her 401k of traditional pre-tax dollars and then contributes $37,000 in after-tax contributions up to the $56,000 limit, the airline (employer) would not have any room to make its contributions to her account, saving the airline from providing this generous benefit.
- Your employer needs to permit periodic “in-service distributions” or “in-plan rollovers” for after-tax contributions and any related earnings. The alternative is that you intend to leave your current employer relatively soon which would then permit you to distribute funds from the plan at the time of separation and get the same result.
Remember from earlier that the growth on
after-tax 401k contributions is, unlike Roth 401k dollars, subject to tax as
ordinary income when distributed. Ideally, what happens is that you make
the after-tax 401k contribution and then immediately (or soon thereafter)
rollover/convert those dollars to a Roth IRA (in the case of in-service
distributions) or rollover those dollars to the Roth 401k (in the case of
in-plan rollovers). If done immediately after the contribution, there is
no growth and so there is no tax. If the conversion or rollover is not
immediate but happens relatively soon after the contribution, the growth should
be minimal and so the resulting taxes are minimal. Moreover, the dollars
are now in the Roth account which means all future growth is tax-free.
And there you have the mega backdoor
Roth contribution.
If one of these five conditions is
not met, then either you cannot use the mega backdoor Roth or it is not likely
to make economic sense. There is an argument that if you check the boxes
for the first four items but not the fifth, that you should go ahead and make
the contributions, anyway. This math depends on several variables (time
until conversion/rollover, time until distribution, investment return, dividend
yield, capital gain rate, tax rates, holding period, and a few others) but it
is generally the case that if the time until conversion is a few years or
longer, you come out better off by investing in tax efficient funds in a
brokerage account rather than making any after-tax 401k contributions.
What if I meet all five
conditions?
If all five of these conditions are
met, then you’re an excellent candidate for mega backdoor Roth
contributions. But as with my son cleaning his room and knowing what needs
to be cleaned, there can still be an implementation problem that destroys all
the value. Provided that all conditions above are met, here is the basic
implementation strategy (in this example, assuming age >50):
- Determine how much you can expect to receive in
employer matches and other contributions over the course of the year if
you make only the $25,000 of 401k deferrals. Let’s assume total
employer contributions to be $10,000.
- Start with the 415 limit of $62,000. Subtract your
$25,000 of deferrals and the $10,000 of expected employer
contributions. This leaves you with $27,000 of room remaining.
- Elect to contribute $27,000 of after-tax contributions
to your 401k over the course of the year.
- Once the contributions are made – or soon, thereafter –
you need to either rollover these after-tax dollars to a Roth 401k account
or to a Roth IRA (in the case of in-service distributions).
Now you’re ready to invest these
mega Roth accounts and take advantage of the tax-free growth. What you have
effectively done here is taken $27,000 of post-tax dollars which would have
otherwise been invested in a regular brokerage account and shifted those dollars
to a Roth account. Whereas any income, dividends, or capital gains from the
$27,000 in the brokerage account would have been subject to taxes, now it grows
and earns free of taxes forever.
What if I want to make mega
backdoor Roth contributions but my employer does not permit after-tax
contributions or does not allow in-service distributions/in-plan rollovers?
Make sure that they understand this
option exists and that it is not hard to implement. It often just requires
an update to the 401k plan agreement to add some permissions. But many
employers – especially small employers – don’t even know the option
exists.
Any closing thoughts?
It’s complicated. That’s not to say
that everyone needs help evaluating their own situation or implementing. It is
just to say this is complicated. In reality, the calculus is even more complex
than I have outlined above. I provided five conditions that need to be met to
proceed with the mega backdoor Roth contributions. Yet for simplicity, I
ignored relevant factors like whether adequate funds already exist outside the
retirement plan accounts or whether retirement before age 55 might be a
possibility.
Moreover, it can make sense to make
the after-tax contributions even if there is no in-plan rollover or in-service
distribution option. I alluded to the math depending on a number of variables
and the expected value (positive or negative) can be calculated – it’s just
that there are too many variables for generalized advice.
All that said, if you meet the five
conditions laid out above and you’re not already exploiting the mega backdoor
Roth contribution strategy, it is probably time to go clean your room.