At The Money: The Mega Backdoor Roth

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Tax deferred portfolio is also known as qualified accounts, have become one of the most popular ways to invest. There are about one hundred million households nearly seventy five percent of every household in America with some sort of a formal tax advantage. Retirement savings total defined contributions are nearly fourteen trillion dollars. The latest edition in your Tax Deferred

Rosa.

He's an expert in qualified retirement accounts and works with clients all over the country. In full disclosure, Dan leads the corporate retirement plans at my Firmer Helts Wealth Management and is one of my partners. So let's start with the basics. Most of our listeners are certainly familiar with four oh one ks, and they're probably familiar with variations such as a ROTH four oh one K or a ROTH IRA. What is a Mega backdoor WROTH?

So a regular four one K allows you to contribute up to twenty four and a half thousand dollars into it.

Right.

The mega backdoor of ROTH feature just allows you to contribute above and beyond that twenty four and a half thousand dollars up to potentially seventy two thousand dollars. So it uses the same type of strategy that you have in your regular backdoor ROTH IRA. Right, that's just a way for high earners to get money into a ROTH account. They're going to make a non inductible contribution to a traditional IRA and then convert that to a ROTH IRA.

So mega backdoor four oh one k ROTH sounds kind of complicated, but it really seems like that's a huge increase in your after tax contributions that theoretically grow tax free and are withdrawn tax free. Is that right?

That's right.

It's it's a cheap when it works and your plan allows it. It's a cheat code, right, There's nothing else out there that's going to allow you to get that much money into a qualified and that means that much rock dollars into a qualified retirement account.

So cheat codes and back doors sounds a little shady. Is this legit with the irs? Have they blessed this? Yeah?

Yeah, it's just the backdoor part that sounds kind of sketchy.

It is.

It is not a gray area, it is not a loophole. It's completely legit. The rules are actually very much clear. The real challenge is just whether or not your plan allows you to use it.

So let's go through that. If the I R S says it's kosher, I would imagine your employer or the benefits provider, maybe even the custodian who who has to sign off on it? Is Is it any of the above or all the above whose approval is required?

Yeah, it's There's really nothing to do with the custodian with this.

It's more of a plan level decision that's going to be made by the employer, right. They're the ones that are going to control the plan design and would ultimately make the decision to offer the after tax contributions in plan Wroth conversion features that make up this megabactoor Wroth. The formul k provider is obviously involved and they need to be able to administer this, but that's generally.

Not a problem.

Huh. So typically twenty four and a half twenty four point five is a regular four oh one K. I'm assuming catch ups and things like that are separate. So if you could go to seventy two thousand in this and it's after tax, why would the employer object? This sounds like a great deal for anyone who wants to throw more money into their four o one K.

Yeah, and this feature has gotten a lot more popular in recent years, but the reality is the most likely answerest to why.

More plans don't do it.

It just doesn't work for every plan after tax contributions and the inplan wealth conversions do add some complexity to the plan design that most importantly, they trigger additional compliance testing, and that extra compliance test thing it failed can prevent the whole strategy from working all together.

So I know our plan in our shop offers this in house, and I've been taking advantage of it personally. So I'm thinking about other service companies, lawyers, accountants, advisors, architects, anybody that's you know, a white collar office with reasonable salaries. It would seem that this should be something that all those people should take advantage of Why don't all of these sort of firms take advantage of it? It sounds like, hey,

Yeah, it was seventy two thousand and actually the total that's you're all in that each individual can get into each plan. But why don't more plans or companies use this feature? Again, it just doesn't always work. So, without getting too deep into the weeds on the compliance tessing side, if the only individuals that are interested in using this feature and contributing making these after tax contributions are the owners and highest wagoarners, it's not going to work.

It's as simple as that.

So the company either has to be big enough or have enough wayjarners where it's just not the top twenty percent or so using it in order for.

It to work.

So what does it typically look like in a firm that does this? What sort of buy in do you need from management as well as the rest of the staff or partnership.

Yeah, I mean listen as far as buying from the staff. If you have a lot of employees that are contributing and maxing out, right, If you have a lot of people that are maxing their contributions and would do more if they could, that's good sign, right, It's worth looking into in that situation. But you also have to have enough highly compensated individuals.

Right if you just have If you have.

Thirty people and eight of them are the big wag journers, it's just again, it's not going to work.

It's going to be top heavy.

So if you have enough highly compensated individuals that are interested in using this feature, there's a good shot at all work.

So I immediately thought of professional services companies, financial advisors, attorneys, accountants, bankers, doctors, etc. But you know, what sort of industries do you see use this? What sort of businesses? Is this really well suited for.

All the professionals that you just listed?

Tech companies, I mean, i'd say all just about all of the big tech companies have this feature available. Again, and I think any industry or any company where a large percentage of the population would be considered highway journers, meaning say over one hundred and fifty hundred sixty thousand dollars a year and that are interested in making these significant contributions.

It could work.

So let's assume you have a traditional four oh one K and everybody is maxing out their twenty four point five plus whatever catch up over fifties out there, and they want to be able to save more money. What is the process like converting that to a megabackdoor roth? Walk us through that process.

Yeah, Ultimately it's going to have to come from the employer, right, so whoever at the company is in charge of running and administering the four to one K will need to be involved in that decision. You know, if you're an influential employee, of course you can try and influence and push on that decision. But ultimately the plan sponsor the employer will work with the four to one K provider to update the plan documents add a couple of features. For the megabackdoor ROTH to work. A plan has to

A ROTH account.

Moving the after tax dollars into WRATH can happen one of two ways first you have an implan WROTH conversion where the after tax dollars are converted to ROTH and stay in the four to one K plan. And the second is an in service distribution where the after tax dollars are rolled into an outside ROTH IRA mplan. ROTH conversion is probably more common. It's just simpler to execute, and it keeps all the money inside the plan.

Huh, I mean this is really attractive. I'm assuming someone reaches out to HR or one of the managing directors or partners or whatever the title is and says, hey, this is a great opportunity. Want don't we do this? Is there like an extra cost? Why would there be any reluctance to do this assuming it's the sort of mix of high wage employees.

Yeah, there is no additional costs. You could say, there's a little bit of an additional headache. Right again, you're adding more complexity, another layer of compliance testing.

So whoever you know is.

In charge of administering the four O one K company? Yeah, maybe it amounts to a little more work, but when it works, it works really well, and these significant benefits far outweigh you know, the minor administrative additional administrative burden.

So we're talking about companies with partners and hr et cetera. What about either a solo practitioner or a ten ninety nine contractor. Can you do this sort of megaback door roth if you're self employed?

Yes, absolutely, megabacdoor roth works perfectly for solo or owner only four one K plans. There are no compliance tests and headaches or administrative burdens when the plant only covers owners.

So we we're.

Huge fans of the megabacdoor wroth in solo formal case.

So let's talk about timing. How does this work? How much are people converting? You know, what does this look like in terms of best practices, either daily or each pay period or quartterally. How often does this occur?

It really depends on the plan or on the plan provider.

Some plans only allow.

A certain number of conversions or distributions each year, which is obviously not ideal and it really kind of pushes the burden onto the participant to figure out when and how to do that. Others have daily automatic roth conversions, which is just awesome.

I've done it both ways, right, I've had the once a.

Year manual paper form after tax conversions and we now have the daily automatic.

Wroth conversions with Fidelity, and it's a game changer. It's great.

As an employee, you don't have too much control over that. It really depends on the provider. But whatever the case, I certainly recommend reaching out to your four to one key provider the first time you do this, the first time you convert, and making sure you get it right, do it.

The right way.

So you and I have talked about this in the past, and you discussed automatic wroth sweeps. Is that something that again gets set up by the provider or the employer or the employee. How do you make sure that each payroll period or in the event of any distribution or yield or dividend, how do you make sure that stays on the wroth side.

Yeah, it's a great point.

So that daily automatic roth sweep or automatic roth conversion is awesome, but only some record keepers, only some providers offer it.

Right.

So the answer, as it usually is with these types of plans, as it depends right. Every plan is different, every provider is different. If your plan does offer it, or if you're not sure, reach out to the four one K provider. If your plan does offer it, the employee generally has to activate this daily automatic growth conversion feature.

All right, so I know my four oh one K is a Fidelity all of these daily sweeps and other things that you know, from my perspective, it was set and forget, I don't have to pay much attention to it. What about some of the other big four oh one K provider Schwab, Vanguard, Is it possible to do it with those? And do they allow for these daily sweeps like what's the landscape look like out there?

Yeah?

As this feature has gotten more and more popular in recent years, which it certainly has, more providers are getting better at it.

Right five years ago, I.

Don't know if anyone outside of Fidelity did it now if there, certainly, if your plan is big enough, you can pretty much do whatever you want for it. I think if Fidelity just happened to be the first one that was really good at administering it.

But other providers are catching up quickly.

Last question. People hear this described as tax free growth forever, and obviously that gets people excited, But what are the risks? What scenarios? Does this not make any sense? Where are you just better off investing in a taxable account?

Yeah, I think the excitement is warranted. I'm a huge fan of the megabactoor roth feature. If your plan offers it and you can afford the extra contributions, my answer is usually do it.

Just keep in mind a couple of things.

First, if you use that in plan Wroth conversion, the money stays in the plan and then follows the Wroth four to H one k rules all right, So that means you generally can't access that money until age fifty nine and a half or distributable event. So I think the biggest thing answer your question when does a taxable account make more sense if present day liquidity is important?

What about out megabeck door roths. Is there the same required minimum withdrawal requirements?

Actually, I think effective last year, the Secure two point zero removed the R and D requirement from Wroth four one case, so there.

Are no rm D requirements for a row for one case.

Really interesting. So if you're working in a firm, or if you're a solo practitioner and you're making a decent amount of money but you want to save more for retirement, the megabackdoor rowth allows you to use after tax dollars up to seventy two thousand to put into this account that will not only grow tax free, but you can withdraw a tax free whenever you want after age fifty nine and a half, with no minimum requirements when you