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Are you maxing out your 401k?

Most would answer by (1) googling for the 401k contribution limit, and then (2) check that their 401k payroll deductions equal the limit. For example, the 2019 contribution limit is $19,000. If you make $100,000/year you’d want to ensure that about $730.76 was being allocated to your 401k ($730.76 deducted per check, times 26 checks = ~$19,000).

What if you could put in 200% more than $19,000 for a total contribution of about $56,000? Of the many ways of getting there, this article outlines one: The Mega Backdoor Roth.

This technique requires level setting on some basics. They’ll form the building blocks for grokking the backdoor. A great place to start is with what a 401k purports to be: a retirement plan.

Retirement Plans

The retirement plan concept is straightforward. It’s characterized by three phases: Contribution, Growth, and Withdrawal. We’ll narrow our discussion of retirement plans to 401k-like things.

Contribution

This phase is nothing more than the contribution of resources to an asset. For the purposes of this article, the Contribution phase is just depositing money into an investment account.

Growth

This phase (hopefully) grows the contributed-to asset over time. Commonly, the asset is an account holding stocks, bonds, or real estate. For the purposes of this article, the Growth phase is growing your money through owning shares in mutual funds.

Withdrawal

This phase is about extracting some asset value. For the purposes of this article, the Withdrawal phase is simply selling some mutual fund shares and withdrawing the resulting money from the investment account. This money is often used to live on (See the 4% rule [10]) in the retirement years.

With these phases spelled out, and the angle of this article a little clearer, we’re ready to define retirement plans a little more precisely. A retirement plan is an investment vehicle with rules for contributing, growing, and withdrawing money.

401k vs. IRA

Two retirement plans differ if their rules differ. For instance, another popular retirement plan is the Individual Retirement Account (IRA). It differs from a 401k in multiple ways. One massive difference is the limit on tax-advantaged contributions. Let’s check out that and other differences in the table below.

Table 1: 401k vs. IRA

Contribution

In Contribution, the 401k must be employer-provided whereas an IRA has no such requirement. IRAs are available at most financial institutions.

The upshot of 401ks being employer sponsored is that the employer will get to decide the mix of available investments. However, with IRAs, you will decide the mix of available investments. This mix will be constrained by the IRA provider.

Lastly, 401ks enable more money to be contributed in a tax-advantaged way relative to the IRA. “Tax-advantaged” means different things depending whether you’re talking about a Traditional or Roth 401k. (We’ll cover Traditional and Roth later.)

Growth

In Growth, tax-advantaged contributions for 401ks and IRAs can be sold or earn interest without a tax consequence. For investment accounts held outside of 401ks or IRAs, selling and earning interest are taxable events.

Withdrawal

In Withdrawal, we have the least interesting row because to understand its implications we need to introduce a couple more concepts: Traditional and Roth.

Traditional vs. Roth

Traditional and Roth are defined in the context of 401ks and IRAs. Specifically,

  • Traditional 401ks exists,
  • Traditional IRAs exists,
  • Roth 401ks exist and
  • Roth IRAs exist.

Since we’ve discussed 401ks vs. IRAs, let’s focus on Traditionals vs. Roths. See the table below.

Table 2: Traditional vs. Roth

Contribution

In Contribution, Traditional allows for pre-tax dollars to be used, allowing you to lower your adjusted gross income. Roth doesn’t provide this benefit. With Roth, you’re using after-tax dollars — it has no effect on your adjusted gross income. (When Roth is combined with IRA another interesting rule emerges that we’ll discuss later.)

Growth

In Growth, there’s no difference from the previous table. So, let’s skip it.

Withdrawal

In Withdrawal, we see big differences. With Traditional, you’ve only deferred taxes. With the Roth, you have eliminated taxes. With a 401k, you can sometimes withdraw money early from the account (e.g., loan for a down payment on a home; check with your provider). In general, withdrawing money is discouraged and so you incur not only taxes but also a penalty when withdrawing early. The Roth is a little more special. You can always pull out the money you’ve contributed, tax free (but not any growth/earnings from those contributions). To pull out any growth/earnings totally tax free at or above 59.5 years old, you must have had the account for 5 years [11].

Truly Maxing Out Your 401k

With the above “basics” out the way, we’re finally ready to see how to fully max out a 401k. The key mechanism enabling this is the conversion. It’s possible to convert from one account to another. For example, it’s possible to convert your Traditional IRA into a Traditional 401k by rolling it into a 401k, for example. Or you could similarly convert it into a Roth IRA or Roth 401k (you’ll need to pay taxes).

The tables we’ve seen so far didn’t include anything about conversions (but the holy grail for the rules, the IRS guidelines, do). This leads to the so called Mega Backdoor Roth. Despite the grandiosity of its name, it’s totally straightforward and underwhelming.

Let me prove it to you. Let’s assume we’re contributing to a Traditional 401k.

  1. Max out your pre-tax contributions.
  2. When possible, make after-tax contributions.
  3. As soon as any after-tax contribution touches your Traditional account, convert that contribution to a Roth 401k (or Roth IRA).
  4. Done.

It’s really this simple. In step 3, we want to do this quickly because any gains made while in your Traditional account will create a tax bill for you when you convert to the Roth. 401k providers should all know about this and have automated means for performing quick conversions on your behalf.

Using this approach, you could go from only socking away $19,000 in a 401k to socking away $56,000.

Remember when I said that combining Roth with IRA could creates a new interesting rule? Well, it gives us an additional Contribution rule: your (adjusted gross) income must be below $137,000 (in 2019) [9]. For folks, who make too much to contribute to a Roth IRA, the Mega Backdoor Roth is one way around that.

The Catch

What’s the catch? To hit the $56,000 limit, you have to be earning enough money to sock away at least $19,000 pre-tax dollars and $37,000 after-tax dollars ($37,000 after-tax is about $57,000 pre-tax).

So if you made $100,000/year, you’d need to be comfortable allocating what’s effectively $76,000 to your retirement ($19,000 pre-tax + $57,000 pre-tax). So, this approach probably won’t be attractive to you until you’re pulling down much more than $100,000/year.

That said, even if you’re not in a position to fully max out your 401k today, putting away a little more using this Mega Backdoor could be a good look.

References

  1. https://www.nolo.com/legal-encyclopedia/retirement-plan-faq.html
  2. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits
  3. https://www.fool.com/retirement/general/2015/07/09/401k-withdrawal-rules-and-options.aspx
  4. https://www.khanacademy.org/economics-finance-domain/core-finance/investment-vehicles-tutorial/ira-401ks/v/401-k-s
  5. https://mbafcpa.com/advisories/roth-401k-rollovers-beware-5-year-rule/
  6. https://www.rothira.com/blog/the-five-year-rule-with-roth-ira-withdrawals
  7. https://investor.vanguard.com/ira/roth-conversion
  8. https://www.irs.gov/newsroom/401k-contribution-limit-increases-to-19000-for-2019-ira-limit-increases-to-6000 [references 402(g) elective deferral limit and 415(c) total contribution limit]
  9. https://www.rothira.com/roth-ira-limits
  10. https://www.investopedia.com/terms/f/four-percent-rule.asp
  11. https://www.bankrate.com/investing/ira/roth-ira-5-year-rule/

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