News & INSIGHTS

By Patrick Swift, Vice President of Wealth Planning | Wealth Advisor

When it comes to retirement savings: Roth dollars are king, which I mentioned in a previous blog about Roth conversions. I wanted to follow that up with another idea around how to boost Roth savings, despite the income limitations that exclude higher-earning individuals from contributing to a Roth IRA.

For 2023, here is who those rules apply to:

• Single or Head of Household filers: MAGI of $138,000 or less (contribution eligibility phased out completely at $153,000)
• Married filing jointly: MAGI of $218,000 or less (contribution eligibility phased out completely at $228,000)

Individuals affected by these limits may have familiarity with what is known as a “Backdoor Roth” strategy. With a backdoor Roth, individuals who are ineligible to contribute to Roth IRAs are still eligible to make a non-deductible contribution to a traditional IRA. Because the contribution to the traditional IRA is made with after-tax dollars, it makes sense to immediately convert that contribution to a Roth IRA, where they can then be re-invested and grow tax-free (rather than growing tax-deferred in the traditional IRA where the earnings would later be taxable upon withdrawal).

The maximum contribution amount in the aforementioned strategy is going to be $6,500 (+ $1,000 for those age 50+), which is the contribution limit applicable to both traditional and Roth IRAs in 2023.

Still with me?

Enter the “Mega Back Door Roth” strategy for 401(k) participants.

The income limits mentioned above do not apply to Roth or After-Tax 401(k) contributions, assuming they are made available by the 401(k)-plan sponsor. Which means, without any fancy strategies, an individual could make regular old Roth 401(k) contributions in any given year regardless of their level of income.

But that is not what constitutes a “mega back door Roth” strategy. If you have additional income you want to save, and your plan allows for both after-tax contributions and in-service withdrawals to a Roth IRA, this is an ideal strategy to bulk up your Roth savings. Here’s how it works.

The maximum dollar amount that can be contributed to an individual’s 401(k) account in 2023 is $66,000. That number includes both employee contributions and employer contributions. Employer contributions are typically made up of two sources: matching contributions and profit-sharing contributions.

If your 401(k)-plan sponsor or provider (often available for plans custodied with Fidelity Investments or Vanguard) allows for “after-tax” contributions, you can contribute more than the employee deferral limit of $22,500.

IMPORTANT: after-tax contributions are treated differently and separately from pre-tax (traditional) or Roth contributions. If your plan is eligible for after-tax contributions, you will have three different eligible contribution elections: traditional or pre-tax, Roth, and after-tax.

What’s the difference? To keep it simple:

• Pre-tax contributions are withheld from your paycheck before you pay Federal and state income taxes; upon withdrawal in the future, you pay income taxes on both the contributions and the earnings.
• Roth contributions are withheld from your paycheck after you pay Federal and state income taxes (your net pay); upon withdrawals in the future, the contributions and earnings are tax-free.

These two types of contributions, regardless of which you elect, make up your regular $22,500 deferral.

• After-tax contributions: can be elected beyond the initial $22,500 deferral up to a total of $66,000 in 2023 (employer match and/or profit-sharing contributions are included in this total). Like Roth contributions, after-tax contributions are withheld from your paycheck after you pay Federal and state income taxes; however, the key difference is that the earnings of the after-tax contributions are treated as taxable income in the future.

Here are two brief examples.

No employer contributions:

• You elect pre-tax contributions and max out the regular $22,500
• Your employer does not match your contributions or provide a profit-sharing contribution ($0)
• The maximum after-tax contribution you can make in 2023 would be $43,500 ($66,000-$22,500=$43,500)*

With employer contributions:

• You elect pre-tax contributions and max out the regular $22,500
• Your employer matches your contributions up to a $9,000 maximum (which you receive entirely)
• The maximum after-tax contribution you can make in 2023 would be $34,500 ($66,000-$22,500-$9,000=$34,500)*

*Note: an additional benefit is that the IRS does NOT count catch-up contributions as part of the total. This means an age 50+ employee in either of the above examples could contribute an additional $7,500 via pre-tax or Roth contributions in 2023. For those counting along, that means maximum total savings could be as much as $73,500 for an age 50+ individual.

If the after-tax option is included in your 401(k) plan and you have additional income to save each year, congratulations – you have 2 out of 3 boxes checked to enable a successful “mega back door Roth” strategy.

To check the third box, your employer must allow for what is referred to as “in-service withdrawals” for the after-tax contributions in your 401(k) plan. This means that regardless of being an active employee, you are allowed to roll over your after-tax contributions each year to a Roth IRA.

The reason this last component is so crucial has to do with how after-tax contributions are treated if left in the 401(k), which I described above. Remember, the earnings on after-tax contributions become taxable upon withdrawal. To lock in the full benefit of those after-tax contributions, you will want to roll over the contributions to a Roth IRA each year, where they can be reinvested for tax-free growth and withdrawals. Ideally, you want to time it right, so that your after-tax contributions have very little opportunity for investment earnings.

Best execution: put as much money as possible into the after-tax bucket and then move that money into a Roth IRA for tax-free growth as soon as possible to avoid taxable earnings.

If your 401(k) plan does not allow for in-service rollovers of after-tax contributions, it does not completely deter the strategy. It just means you will have to wait to roll over those after-tax contributions until you leave your employer. At that point, you will have more taxable earnings in your 401(k), but you are still able to roll over and reinvest the original after-tax contributions in a Roth IRA.

To summarize the “Mega Back Door Roth” strategy:

• Your employer must allow for after-tax contributions to the 401(k) plan.
• Your employer allows you to move your after-tax contributions to a Roth IRA.
• You have sufficient cash flow from your paycheck for additional savings.

Lastly, let me touch on why this strategy is so timely right now.

Minimal change to cash flow. In my experience, in any normal year, those who max out their initial 401(k) contributions have either already reached that limit at this point in the year or are close to doing so. This means they are accustomed to the automated 401(k) deduction and resulting paycheck, and by electing an after-tax contribution, they are not experiencing an enormous change in their monthly cash flow.

Minimal earnings on after-tax contributions. Admittedly this takes some finagling, but as mentioned above, if you can get as close to the $66,000 maximum via after-tax contributions in as short a period of time as possible, those after-tax contributions will not have much of a chance to grow into taxable earnings. Once January rolls around, the contributions will be eligible for rollover to a Roth IRA for reinvestment.

Large annual expenses are paid. This one is a bit subjective, but I have found that aside from the upcoming holidays, most people have already paid most of their “big-ticket” expenses for the year: vacations, tuition at the beginning of a semester, renovation projects, etc.

Proposed tax changes. There was proposed legislation in 2021 to eliminate or greatly reduce the ability to create “mega back door Roth” contributions. It did not pass, but it has been in the crosshairs of some lawmakers in Congress. It is worth considering, as this strategy may not be available in the future.

Please reach out to us with questions – we have deep expertise assisting clients explore their 401(k) plan options. As always, please consult with the appropriate tax and financial professionals before making any decisions about your situation. Feel free to send an email to me at pswift@ampliuswealth.com.

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