What is a Mega Back Door Roth IRA?

Updated with 2022 numbers on 9/21/22

What if I told you that your employer might offer a benefit so valuable that it could create hundreds of thousands of dollars in tax-free money for you to access at age 60? What if I told you this benefit is as rare and elusive as an affordable and consistently delicious neighborhood restaurant? Would you believe me? I wouldn’t believe me. I’m of course referring to the Mega Back Door Roth IRA (MBDR)- a benefit offered RARELY by employers but one that can be extremely valuable if used correctly.

If your employer is one of the select few that allows post-tax contributions that means you could potentially save an additional $40,500 tax-free towards your financial independence goal. Why are we so obsessed with tax-deferred and tax-free investing? Because a dollar invested in a 401(k) will not be taxed annually like a dollar invested in a regular brokerage account. Over time, your gains in your 401(k) or IRA will be permitted to grow for DECADES without ever being taxed until you pull the money out, whereas, with a regular taxable brokerage account, your dividends, interests, and gains are taxed every single year. And if the account is a Roth account, you’ll never pay tax on those dollars again.

The MBDR is HUGE because of the additional $40,500 that can be saved in a tax-deferred retirement account, and in this case, it’s a tax-free retirement account because of its Roth status. Most companies don’t allow the use of a Mega Back Door Roth feature but we’ve seen companies like Google and Apple introduce this benefit for employees and then younger tech companies like Asana and Spotify follow suit. The reason it isn’t offered more widely is due to special testing rules for 401(k)s plans that prevent highly paid employees from contributing more to a 401(k) than lower-paid employees.

How does it work?

Now the mechanics of retirement accounts and who pays tax when will send your head spinning down the road. What you need to know for the MBDR is that there are THREE parts that make up the total 401(k) contribution: the employee contribution which can be Roth or Traditional, the employer match, and the additional post-tax contribution (MBDR) allowed by select 401(k) plans.

Let’s look at an example to see how someone making $200,000 would be able to save almost $60,000 into tax-advantaged accounts in just one year. There’s the standard 401(k) contribution of $20,500 for 2022. This person’s employer offers a match of 3% and the remainder is available for the employee to contribute post-tax savings. Remember post-tax means that the dollars have already been taxed so there is no immediate tax benefit THIS year on the contribution over the standard $20,500 - you never get a reduction in your taxable income by contributing dollars to a Roth account.

Why is this such a good idea?

Saving an additional $40,500 a year sounds great, right? If you did that for just five years during your late 20s you’d have nearly a quarter of a million dollars Neat! But that’s just with zero interest or earnings. What happens mechanically is this: dollars contributed to the post-tax portion of your 401(k) are then converted to a Roth IRA annually and then can be invested in mutual funds and ETFs (the choices are determined by your employer). This is called an “in-service” withdrawal - meaning that you’re actually taking dollars out of your employer’s 401(k) and putting them in your own IRA (remember the I in IRA stands for Individual). Some plans allow the funds to be automatically converted after each paycheck deposit which I think makes this process very easy.

And remember, these are post-tax Roth dollars that should be invested in a diversified portfolio so when you withdraw them safely after age 59, you’ll never pay tax on those dollars again. One more time for the people in the back: max that shit out as long as you can and you’ll have multiple millions in tax-free money to spend after age 59.

When is this not a good idea?

The biggest barrier to contributing to a MBDR is cash flow. If you don’t currently have the ability to save more of your paycheck, then the additional savings probably aren’t a good idea. It’s not worth it to experience financial stress in the form of credit card debt to unlock this benefit. However, it’s something to strive towards, perhaps when you get that next raise. You also don’t have to do the full max right away, start with something reasonable like 5% and work your way up. It also doesn’t make sense to do the MBDR if you aren’t already contributing the full $20,500 and maxing out the regular portion of the 401(k).

This seems like a lot of money to lock up until age 60, what if I want to have access to this money sooner?

It’s true, this is a lot of money to save in an account that isn’t meant to be accessed until retirement, but you’d also be paying a lot in taxes if you kept these funds in a regular taxable account. If your ONLY source of income is your salary, yes $40,500 could be a hefty chunk of your income. But, if you’re like most of our clients, and you have other sources of income like equity compensation in the form of RSUs or stock options. So if your salary is $200,000 but you also have $50,000 of RSUs vesting and you’re going to sell another $100,000 worth of NQOs - you’re looking at total compensation of $350,000 pre-tax. Using very simple math - maxing out your Mega Back Door Roth would only require 12% of your total compensation. Add that to your regular 401(k) contribution and you end up with about 18% going into long-term tax-advantaged savings. 18% is pretty close to 20%, which is a fantastic target for how much of your income should go to retirement savings.

How do I know if my employer offers this?

When a new financial planning client comes onboard one of the first documents we ask for is the Summary Plan Document for their employer’s 401(k). This document tells us what the client can invest in, what the restrictions are, whether the client can take a loan from the 401(k), whether the plan allows Roth contributions, and MOST importantly: whether the plan allows post-tax contributions aka the Mega Back Door Roth.

How do I sign up?

The ability to contribute to a MDBR is usually found at the custodian who holds your 401(k): Fidelity, Vanguard, Betterment, Transamerica, Mass Mutual…there are many others. Log in and change the contribution percentage from your paycheck. The calculation can be straightforward by dividing the contribution limit ($40,500 if NO employer match) by your annual salary. Back out the employer match if one is offered. Some companies like Amazon will limit the percentage you can contribute to something like 10%, it’s still a good idea even if you can’t do the full $40,500. To contribute to the Mega Back Door Roth you’ll want to input a percentage of your paycheck in the “Post-Tax” or “After-Tax” contribution box. WARNING: do not put it in the “Roth 401(k)” box - that is something different entirely!