Post-Tax 401(k)s and the Mega Backdoor Roth

Every 401(k) plan has an overall IRS-mandated limit of $55K (for 2018). Contributions to a plan fall into three parts:

  • Your tax-advantaged contribution (up to $18.5K),
  • Your employer's contribution, and
  • Your post-tax contribution, which can be converted to a Roth.

So, for example, if you worked at Google (which matches 50% of your contribution, making for easy math) and maxed out everything, you'd have:

  • $18,500 in tax-advantaged contribution,
  • ($18,500 * 50%) = $9,250 in employer match, and
  • ($55,000 - $18,500 - $9,250) = $27,250 in post-tax, mega-backdoor-Rothable contribution.

Why would you do this? Frankly, it's a terrible strategy if you just stop there. Money in a post-tax 401(k) is still subject to taxes on dividends, so it's kinda like a brokerage account with an early withdraw penalty: the worst of both worlds.

However, once you've contributed to your post-tax 401(k) you can immediately roll that money over into a Roth IRA. It's then subject to all the benefits of a Roth account: no additional taxes on gains or dividends, no taxes when the money's withdrawn, and access to the principal at any time.

This strategy is called a mega backdoor Roth. That's not the formal IRS name, of course, since it's a bit of a loophole and not exactly officially endorsed, but that's the name the financial enthusiast community has given it.

Your plan might also allow an in-plan rollover. In that case, you can roll it over into a Roth 401(k) instead of an IRA. You might want to do this if:

  1. Your 401(k) provider offers better funds than your IRA provider (some big tech companies, for example, have exceptionally good low-fee funds available), or
  2. Your 401(k) and IRA providers are different. The rollover process might be painful and you may prefer to avoid it.

We mentioned above that money in a post-tax 401(k) is still subject to taxes on capital gains and dividends. Since that's the case, it behooves you to roll that money into your Roth account immediately upon receiving it. Consider setting a recurring event on your calendar so you can initiate the rollover within a day (or, better, a couple hours) of the money hitting your 401(k). It's no fun to file additional tax paperwork for a couple cents worth of gains.

There are a few constraints on mega backdoor Roths. The biggest one is that your plan custodian—that is, the company managing the 401(k)—needs to support post-tax contributions. Many don't, but I've heard anecdotal estimates that about half of them do, so it's at least worth investigating.

This strategy is a bit esoteric. If you're not at an especially large company your HR department probably doesn't know about it, and they may have difficulty assisting you. If you're not sure what you're doing, this might be a good time to hire a fee-based advisor to help you.

The Mad Fientist and White Coat Investor have some great articles on mega backdoor Roths.

As always, the IRS rules are the ultimate (and surprisingly readable) authority.

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