How does Mega Backdoor Roth work?

The Mega Backdoor Roth is a financial strategy that allows you to contribute significantly more to a Roth IRA beyond typical limits. Here’s a simplified breakdown of how it works:

1. Understand Contribution Types: Your employer's 401(k) plan can include three types of contributions: pre-tax, employer matching, and after-tax. Normally, you may already maximize the pre-tax contributions and your employer's match.

2. Maximize After-Tax Contributions: The total allowable 401(k) contribution limit is substantial (e.g., $66,000 for 2023). After maxing out your regular contributions, any remaining room up to this limit can be filled with after-tax contributions. For instance, if your combined pre-tax and employer contributions total $30,000, you can contribute an additional after-tax amount up to $36,000.

3. In-Service Distributions: You can then transfer these after-tax contributions to a Roth IRA through what’s called an in-service distribution. This transfer allows your contributions to grow tax-free in a Roth IRA, avoiding taxes on earnings when you withdraw in retirement. Not all employer plans allow in-service distributions, so check with your HR department or 401(k) plan administrator to see if this is an option 1 2.

4. Two-Step Process: Alternatively, you can execute a two-step transaction. First, make after-tax contributions to your 401(k). Second, either roll these contributions directly into a Roth IRA shortly after making them, or convert them to a Roth 401(k) within the same plan if allowed. This strategy generally results in minimal additional taxes since only earnings during the short holding period are taxed 3.

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5. Employer Plan Specifics: It's essential that your employer’s plan supports after-tax contributions and in-service distributions. This feature isn't universal, and some plans may have additional requirements like compliance testing for highly compensated employees 4.

This strategy can significantly boost your Roth savings, but always confirm the details with your plan provider to ensure everything is set up correctly and compliant with IRS regulations.