Microsoft recently led the way in creating a rarely utilized benefit within their 401(k) plan – the after-tax Roth conversion, also known as the Mega Backdoor Roth. Slowly but surely, other companies are adopting this plan feature. If you’re one of Microsoft’s team members, you’re likely aware that you can contribute $19,500 for 2020 and you’ll receive a 50% match. What you might not know is that the IRS limit on 401(k) contributions from all sources is $57,000 for 2020. So, in Microsoft’s plan, you can invest and additional $27,750 in the Roth account through this conversion strategy, providing tax-free growth for retirement. So, how does it work, what other companies offer it and is it worth it?
What’s so great about a Roth?
First, why so much fuss about a Roth? Well, in short, taxes. Every dollar withdrawn from your pre-tax 401(k) is taxed as income in retirement. Even funds taken from a brokerage account have capital gain taxes. However, in a Roth, every dollar you withdraw is yours to spend – tax-free.
Why is this benefit unique?
A Roth 401(k) is a standard option these days that grows your savings tax-free. Many plans also allow after-tax savings beyond your standard contribution and match, though growth from these funds would be taxed in retirement. Microsoft’s 401(k) plan paved the way with the IRS for you to be able to convert those after-tax funds into a Roth. This concept is borrowed from the Back Door Roth IRA contribution, but, with a $27,750 limit for 2020, you can contribute quite a bit more than the $6,000 you can typically save into a Roth IRA. So, if you could be using this strategy, what might it mean in real dollars?
Real World Example
Let’s say you’re 40 years old, plan to retire at age 60 and save an additional $25,000 each year using this Roth conversion strategy beyond your basic 401(k) contribution. If you earn 7% on your money, you’ll have just over $1 million in additional retirement savings. And, better yet, you won’t have to pay taxes on any of it! In this same situation, had we saved the same $25,000 per year and earned the same 7% in a brokerage account, all dividends, interest, and capital gains would be taxable and could lead to $100,000 or more in taxes.
Who should be using this?
After these rave reviews, shouldn’t everyone with the Mega Backdoor Roth option use it? Well, first, we’d advise that you maximize your basic 401(k) contribution and take advantage of the 50% employer match. This is $9,750 of “free money” that you only get through standard 401(k) contributions. If you like the tax-free idea, you can redirect your contributions to the Roth 401(k) option to allow those dollars to grow tax-free. Keep in mind that you’ll give up the tax deduction on the front end and matching dollars will still be taxed when you take them out.
Also, note that these numbers will be slightly different if you’re over 50 as you have an additional $6,500 you’re able to put into your regular 401(k) as a catch up.
What other companies offer this benefit?
This in-plan Roth conversion feature is slowly gaining traction with other companies but is still not widely available. However, here are a few other companies that also offer this feature:
You’ll want to confirm directly with your HR contact if this applies to you, but, if it does, it’s worth checking out. Each situation is unique, so reach out to your advising team to find out if this benefit is right for your financial plan!
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