If you’re a big saver you’re probably already maxing out your 401(k), HSA, and IRA if you aren’t above the income limit. Most savers always want to know the next tax advantaged account to save in, but if you’re an employee your options are probably limited. The Mega Back-Door Roth Conversion, a less well-known, and potentially huge opportunity, is out there for those supercharging their retirement planning or simply looking to maximize their tax-free money. This planning strategy works best for:
- Pre-Retirees less than 3 years from retirement.
- People who believe they will be changing jobs in the next 2-3 years.
- Your employer’s 401(k) allows in-service distributions or in-plan Roth rollovers (very rare).
Most employees think their 401(k) employer retirement plan only allows them to contribute $19,500 if under age 50 or $26,000 if over age 50. What they don’t know is the actual total all 401(k) plans allow for is $57,000 in employee and employer contributions.
However, once you’ve maxed out the employee portion, you have a unique opportunity to fill the rest of the $57,000 (less employer contributions) in Non-Roth Post Tax Contributions. There’s no tax deduction for this, and the money sits in “limbo” within the 401(k) as it stays invested. It’s not pre-tax and it’s not Roth money.
There are a few different ways to roll over this non-Roth money: The simplest would be separation of service. The after-tax money will remain invested within the account and all the gains will invest on a pre-tax basis.
For example, let’s pretend you contributed $37k in after-tax non-Roth money and it grew to $47k. If you were to change jobs and roll over your old 401(k) plan, the “basis” of $37k could be dumped into your Roth IRA while the $10k of investment earnings will go into your traditional IRA! While we don’t want your money locked up and not growing tax free forever, if you know you’ll be separating from service in the next 2-3 years it can be a great way to create a $100k Roth IRA for yourself. This strategy is perfect for pre-retirees looking to supercharge their retirement accounts before they retire.
There’s a more advantageous, but rarer way for these to work as well.
Some 401(k) plans, while rare, will allow for in-service rollover options or, even better, in-plan Roth rollover options. For in-service rollovers, this would allow you to distribute a portion of your 401(k) and take the after-tax non-Roth money and roll it into your IRA in the same year!
An even simpler option allows for the after-tax non-Roth money in your 401(k) to be rolled into the Roth 401(k) portion of your employer plan through “in-plan Roth rollovers.” While these options are rare, it makes the Mega Back Door Roth an even more advantageous option for serious savers.
How does the distribution work?
If there’s pre-tax money, Roth money, and after-tax non-Roth money how do you receive the funds? Can you cherry pick? It’s a great question and one that must be considered with this strategy:
Any distribution from your employer plan will be on a pro-rata basis. Let’s pretend your 401(k) balance is $100k, made up of $80k pre-tax and $20k after-tax non-Roth money. If you took a distribution of $50k from the plan, $40k would be pre-tax and $10k would be after-tax non-Roth money. It’s an important piece to note in all this.
The beauty of supercharging the after-tax money for 1-3 years before you either change jobs or retire is you can roll over the WHOLE balance of the 401(k). This means there are no issues with pro-rata rules because you receive 100% of the account!
Something to keep in mind…
Not all employer plans allow Non-Roth Post Tax Contributions, but you’d be surprised how many do. The first step in investigating this option is checking with your company’s HR department and reviewing your 401(k)’s Retirement Plan Document.
From there, we strongly suggest contacting a professional CPA and/or financial advisor as this is a very complicated technique with multiple moving parts. Working with a professional will ensure you are taking the right steps and not doing anything wrong in the eyes of the IRS. Please feel free to contact Denver Private Wealth Management with any questions.
Denver Private Wealth Management is an independent fee-based financial planning practice with 50+ years of experience in the financial industry. DWPM customizes portfolios based on your financial goals and works closely with you, your tax advisors and estate attorneys to form a comprehensive view of your financial situation. For more information or to set up a free consultation, contact us at firstname.lastname@example.org.
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