Microsoft led the way in creating a rarely utilized benefit within their 401(k) plan – the after-tax Roth conversion, or Mega Backdoor Roth. Other companies are slowly adopting this plan feature. Beyond the standard maximum contribution and any matching, the IRS allows non-deductible contributions up to a total of $58,000 from all sources in 2021. So, if you make the $19,500 maximum contribution and receive an $8,500 match, you would still have $30,000 left to go. If converted to Roth, this could add significant tax-free retirement income. So how does it work?
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 Every dollar withdrawn from your pre-tax 401(k) is taxed as income in retirement.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.
If your company offers this benefit, it’s worth checking out!
I’m a Solopreneur…am I out of luck?
Fortunately, there’s an option for you! Read our Mega Backdoor Roth Solo 401(k) for Solopreneurs guide.
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