How to “Mega” Your 401(k) and Cut Your Taxes

The IRS limits how much you and your employees can contribute to your 401(k) and still get tax benefits. Currently, the maximum you can save pre-tax is $22,500 per year ($30,000 per year if you’re 50 or older). Business owners and high earners who would like to build a bigger nest egg often turn to brokerage accounts, but this opens them up to paying taxes on both ends: they invest after-tax dollars and then could pay up to 20% on their earnings.

Fortunately, for frustrated business owners, there’s another option.

A mega backdoor Roth strategy allows you to contribute up to an additional $43,500 in 2023 to your 401(k) via an after-tax bucket. You can then convert those funds from after-tax assets to Roth assets, which makes your earnings on those dollars tax-free when you retire. This combination of more retirement savings and tax-free distributions can significantly boost your retirement income.

Requirements for Your 401(k) Plan

Not every 401(k) plan allows you to apply a mega backdoor strategy. Check with your plan provider to find out whether it meets these four requirements:

• Your 401(k) allows for Roth contributions
  This feature permits the 401(k) plan to hold Roth assets.
• After-tax contributions are allowed
  Many 401(k) plans don’t allow participants to make separate, after-tax contributions into their 401(k) plan.
• In-plan conversions are allowed
  This means your plan allows you to convert after-tax contributions to Roth assets (which is what allows your earnings to grow tax-free).
• You have additional dollars to invest
  If you already maxed out 401(k) savings each year and still have cash to save, those extra dollars can go toward a mega backdoor Roth 401(k).

How Much Can You Really Save?

Tax savings with a mega backdoor Roth strategy can vary based on your expected income in retirement, so consult with your accountant or tax advisor before making any decisions. But consider this example.

Brad and Alicia are business partners. They’re about the same age, both earn well into six figures, have maxed out their 401(k) savings, and have extra cash they want to invest for retirement. From age 40 to 64, Brad invests $20,000 per year in a brokerage account. This is done on a post-tax basis. From age 40 to 64, Alicia contributes $20,000 to her 401(k) via after-tax contributions, which she then converts to Roth assets within the 401(k) plan. They both retire at age 65, earn 7% per year on their investments, and take $105,000 in annual withdrawals after retirement. But here’s the big difference: by age 90, Brad has paid $247,748 in taxes on his additional investments while Alicia hasn’t paid a dime.

Additional Benefits of a Mega Backdoor Strategy

• Earnings are Never Taxed
  A mega backdoor strategy offers savers increased access to Roth assets. The main benefit of having Roth assets is that the earnings grow tax-free, and withdrawals aren’t taxed in retirement. This means earnings on Roth assets are NEVER TAXED, which can be a hugely impactful benefit.
• No income restrictions
  Unlike contributing to a Roth IRA, using a mega backdoor Roth strategy has no income restrictions. For example, many high-earners aren’t able to contribute to a Roth IRA at all because their income is too high. However, when Roth contributions are made through the 401(k) (like in a mega backdoor strategy), the high earner is able to effectively bypass income restrictions!
• No RMDs
  So long as Roth assets are rolled into a Roth IRA prior to age 70 ½, they aren’t subject to required minimum distribution (RMD) rules. Most other contribution types require investors to start taking annual distributions starting at age 70 ½. Many people choose to roll their 401(k) assets into an IRA after they retire.
• Tax Diversification
  A mega backdoor strategy gives savers the flexibility to control their tax diversification. Savers are able to determine whether it makes the most sense for them to pay taxes today via Roth (or after-tax) contributions or to pay taxes during retirement via traditional pre-tax contributions. Typically savers do a combination of both so they can enjoy tax benefits today, as well as in retirement.

Is a Mega Backdoor Roth Always the Right Choice?

A mega backdoor Roth strategy doesn’t make sense for every retirement saver. It’s not a good fit if:

• You aren’t yet able to max out your personal 401(k) contributions.
• You need access to the assets prior to retirement.
• You’re already meeting your retirement savings goals and tax diversification goals.

What’s important is that you and your employees have options. This starts with offering a Roth feature as part of your 401(k) plan, allowing for after-tax contributions in the 401(k) plan, and permitting in-plan Roth conversions. Education is also a critical factor. Participants need to know about the benefits that a mega backdoor Roth can offer and have someone in their corner who can help them build a plan that meets their needs.

Let's Make a Plan

Fisher’s retirement plan specialists consult one-on-one with plan participants to help folks get on track to achieve their retirement savings and tax diversification goals. Give us a call today to begin building your strategy.