Almost every advisor and serious retirement saver out there understands the basic limits that apply to pre-tax contributions to a 401(k) account, whether a Roth or a traditional account.
These clients are likely also well versed in the traditional backdoor Roth IRA, which allows clients to convert IRA funds to a Roth IRA. What many clients fail to grasp, however, is the fact that some clients with high saving potential may be able to stretch the limits of the added value of a Roth’s tax-free withdrawals by contributing to a backdoor Roth 401(k) by using special contribution rules to access the “backdoor” to the Roth 401(k). By paying close attention to both the IRS rules and the plan-specific rules that may apply, the client may be able to nearly triple the level of funds that are funneled into their overall 401(k) strategy while significantly increasing the level of funds that are available to grow and be withdrawn tax-free in the process.
Benefits of the Mega-Backdoor Roth 401(k)
The basic IRS 401(k) contribution rules allow a client under age 50 to contribute up to $19,000 in pre-tax funds to his or her 401(k) in 2019 ($25,000 for clients who have reached age 50). However, the overall contribution limit that applies to employer, employee pre-tax and employee after-tax contributions combined is $56,000 (or $62,000 for clients 50 and over).
Because of this, some clients may be able to significantly increase the level of after-tax contributions added into the 401(k). However, if those after-tax contributions are left in the traditional 401(k), the earnings on those contributions will eventually be subject to tax at the client’s ordinary income tax rate—even though the after-tax contribution itself could be withdrawn tax-free.
Roth 401(k)s are subject to the same contribution limits as traditional 401(k)s, but are treated differently from a tax perspective. The second that the after-tax contribution is funneled into the Roth portion of the 401(k) (or into a Roth IRA), those same earnings begin to grow on a tax-free basis—meaning that those earnings are not subject to tax as they accrue within the Roth and they are not subject to tax when withdrawn, so long as the applicable withdrawal rules are followed.
Using this backdoor strategy, the client is essentially able to “supersize” the value of the after-tax contributions by generating tax-free growth on even the earnings portion of those larger contribution amounts (note that direct Roth IRA contributions are currently limited to only $6,000 in 2019)—especially if the client plans to leave the funds invested in the Roth for a significant period of time.