Is the Mega Backdoor Roth IRA Worth it

In 2020, we suffered through a pandemic where stocks initially dropped like it was hot in March. But for those individuals lucky enough to be working at a hot IPO, you suddenly found yourself flush with RSU cash by December. Congratulations to all the employees who work at DoorDash, Snowflake, AirBnB, C3.ai, Draftkings who all suddenly find themselves among the top 1% of U.S. earners.

Not to be outdone by IPOs, many large tech stocks were able to ride the wake to new all-time highs such as Google, Facebook, Microsoft, Tesla, Apple, Workday, SalesForce, Oracle. Even Uber joined the party, where employees were crying foul about the poor IPO debut in 2019. Nobody at Uber should be crying now that Uber is worth over $95B as of this blog post. Hopefully, Uber employees listened to my advice and just held the Uber RSU shares where they can use those capital loss claims to offset the recent huge gains. Just remember to align the tax lots (i.e. short-term capital loss with short-term capital gains).

With all this new found wealth among Silicon Valley, I am here to help you to become financially responsible. If you have been following my blog, you already know about my wealth building strategies from previous posts. Wealth building strategies that include maxing out your 401k or the Roth 401k will help lower your AGI when it comes time to pay RSU taxes. If you have already exhausted all your retirement strategies (e.g. 401k, Roth 401k, Roth IRA) then allow me to introduce you to the Mega Backdoor Roth IRA. — The Mega Backdoor Roth IRA is another good retirement strategy that is for the ultra high income earners.

What is a Mega Backdoor Roth IRA

Both my wife and I already have Roth IRA accounts but we stopped contributing because our income exceeds the income limit. Roth IRA income limits for 2021 start at $140,000 single or $208,000 married. The Roth 401k program does not impose income limits however you are capped by the 401k limit of $19,500. Allow me to introduce the Mega Backdoor Roth IRA strategy.

The Mega Backdoor Roth IRA strategy allows you to save up to an additional $37,500 after-tax contributions on top of the $19,500 401k limit. The only caveat is if your employer’s retirement plan allows for in-service withdrawals of these after-tax contributions, or you plan to leave your job in the near future.

Here’s a checklist to determine if a Mega Backdoor Roth IRA is possible for you:

• You earn more than $140,000 (single) or $208,000 (married) in 2021.
• You max out your employer’s annual 401k and Roth 401k contribution limit of $19,500 (or $26,000 if you’re over 50) in 2021.
• You have an employer retirement plan that allows after-tax contributions outside of Roth 401k and can make in-service withdrawals.
• You plan to leave your job in the near future. I would only recommend this route if you can live without the after-tax money.

Mega backdoor Roth IRA contribution limit

I created the following graphic which breaks down the contribution limits into 4x distinct jars. For 2021, the total retirement account limit which is the summation of all 4x jars (pre-tax, after-tax, and employer matching contributions) are capped at $58,000 ($64,500 if you’re over age 50) in 2021.

• Jar #1: 401k pre-tax contribution; Jar #1 + Jar #2 = $19,500 limit ($26,000 if you’re over 50)
• Jar #2: Roth 401k after-tax contribution; Jar #1 + Jar #2 = $19,500 limit ($26,000 if you’re over 50)
• Jar #3: Mega Backdoor Roth IRA after-tax contribution; Jar #3 + Jar #4 = $38,500
• Jar #4: Employer Match contribution; Jar #3 + Jar #4 = $38,500

Steps to create a Mega Backdoor Roth IRA

1. To start the Mega Backdoor Roth IRA, check that your company’s 401k provider allows for making after-tax contributions which is different from 401k and Roth 401k contributions (Jar #1 + Jar #2).
2. Allocate a portion of your income towards this after-tax contribution. Be careful not to exceed the Mega Backdoor Roth IRA limit of $38,500 for 2021 (Jar #3 + Jar #4).
3. Open a new Roth IRA if you do not have one already established.
4. Make an in-service distribution withdrawal of your after-tax contributions into your Roth IRA through your 401k provider.
5. Alternatively, if you’re unable to make in-service distributions, you can still make after-tax contributions and move those funds to your Roth IRA when you leave your job.

Quick Summary

If you have already exhausted all your retirement strategies (e.g. maxed out 401k, took advantage of Roth 401k, Roth IRA) then allow me to introduce you to the Mega Backdoor Roth IRA. — The Mega Backdoor Roth IRA is another good retirement strategy that is for the ultra high income earners.

Here’s a checklist to determine if a Mega Backdoor Roth IRA is possible for you:

• You earn more than $140,000 (single) or $208,000 (married) in 2021.
• You max out your employer’s annual 401k and Roth 401k contribution limit of $19,500 (or $26,000 if you’re over 50) in 2021.
• You have an employer retirement plan that allows after-tax contributions outside of Roth 401k and can make in-service withdrawals.
• You plan to leave your job in the near future. I would only recommend this route if you can live without the after-tax money.

Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services.

Does your 401k provider allow after-tax contributions? I would imagine most companies in Silicon Valley have this option today. Let me know in the comments.