Over the past two decades, doctors have overwhelmingly turned to evidence based medicine (EBM) – the conscientious use of clinical experience and research to make decisions about the care of patients.  Evidence based medicine is about applying the current best evidence, systematic reviews, and the scientific method to the treatment of patients.  The result has been more informed decisions and better outcomes.  `

Evidence based investing (EBI) – the foundation of Golden Bell’s investment approach – judiciously applies the same concepts of evidence based medicine to investing.  We use the long-term evidence of capital markets to formulate optimal investment solutions and apply an objective discipline to achieve better outcomes.  

Even though there is robust and nearly irrefutable evidence that investors overwhelmingly achieve better results by rejecting actively managed funds, market timing strategies, individual stock selection, macroeconomic forecasts, and subjective decision making, most investors still rely on such sub-optimal and under-performing strategies.  These investors follow unscientific models based on untested hypotheses and the idea that they have some special knowledge that is largely unknown to the market or the professional investment community.  Fear and greed – rather than evidence – dictate investment decisions.  As Albert Einstein said, “The definition of insanity is doing the same thing over and over again but expecting different results.”

At Golden Bell, we maintain enough humility to appreciate that we are not immune to the same behavioral shortcomings of all humans.  Just because we may be smart, experienced, and have unique access to information does not mean we are better at predicting short-term market movements. 

Our evidence based investing approach – one that has been stress-tested by researchers at the University of Chicago, Yale, MIT, and other academic institutions – applies a systematic discipline to remove emotion and filter out the never-ending avalanche of forecasts, opinions, and noise.  It is not about predicting the next market swing – it is about avoiding the most common of investor mistakes.  While overwhelmingly simple and unexciting, it is a discipline that exploits investment diversification, employs low cost, passive investments, in a tax-efficient manner, and seeks to capture historically reliable long-term risk premiums.  

At the end of the day, our evidence based approach is intended to maximize growth and consistency while minimizing risk, taxes, and emotion.  You will have to get your emotional fix elsewhere. 

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): 

1. 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. 
2. 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.
3. Elect to contribute $27,000 of after-tax contributions to your 401k over the course of the year.
4. 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.