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The TLDR on the Mega Backdoor Roth (2023)
How to invest an extra $43,500 beyond the IRA contribution limit of $6,500 in 2023
Disclaimer: The mega backdoor can get messy quickly. Consult a tax professional.
While I am not the biggest fan of retirement accounts for previously stated reasons, I think that understanding how to take maximum advantage of them is important to know.
The Mega Backdoor Roth is something I've seen explained elsewhere so poorly that I think it deserves it's own blog post. So many articles take f—-ing forever to get to the point, it's reminiscent of those baking recipe results on google search where you've gotta hear someone's whole life story in long essay form before you learn what temperature to preheat the oven. So here's a TLDR version followed up by a long version.
As a bonus, I’ve also included some tips for young professionals at the bottom of my post that have some unorthodox ways to use your 401k/IRA.
The short story
Contribute up to $43,500 in post-tax dollars to an “after tax” 401k, and then roll it into a roth 401k or roth IRA. Or roll it over after every pay period for maximum benefit.
401k types
Traditional 401k: no income tax in → income tax on withdrawal.
Roth 401k: income tax in → no income tax on withdrawal
After tax 401k: income tax in → income tax on withdrawal (or deferred by transferring gains to a traditional IRA)
With the after tax 401k, you get double taxed. Sounds awful, right? Here's the catch: you can use after tax 401k as a temporary "limbo" state to stuff $43,500 more into your Roth IRA.
The goal is to minimize the amount of time that your money spends in the after-tax 401k and get it into your roth 401k/IRA as quickly as possible. If you do incur gains during the limbo period, your employer plan may give you the option to withhold taxes, or they may offer to put your gains into a traditional IRA (at which point you’re subject to the pro-rata rule and pay taxes when you convert traditional → roth).
That's it. That's the gist of the mega backdoor roth. 6.69x more into your roth ira.
The long story
The Mega Backdoor Roth: This allows you to put $43,500 of money per year into Roth IRA, but only if your employer has an "after tax" 401k that you can contribute to. The after tax account is NOT a roth or traditional 401k, it's a separate thing.
The process works like this:
You contribute up to $43,500 per year in your after tax.
You call up your 401k custodian and ask for an “in service withdrawal” of your after tax funds into a roth IRA.
Your capital gains will be rolled into a traditional IRA, where you’ll have to deal with the pro-rata rule. You pay income tax when you convert post-tax dollars in your traditional IRA into a roth IRA.
You effectively pay regular income tax on any capital gains from between when you deposited the money in your aftertax and when you roll it over to your roth IRA. This is what makes after tax different than roth accounts: with both types you pay income taxes up front, but with a roth you do not pay taxes on your capital gains. With an after tax, you do. This makes the aftertax an inferior tax advantaged account because you're getting taxed on both ends. It also has extra steps, which makes it more of a headache to execute.
The only reason to have your money in the after tax 401k is so that you can get it into a roth IRA, because it allows you to contribute another $43,500 amount to your roth above the standard contribution amount of $6,500.
In practice, you’ll do something like this
Set up destination roth and traditional IRA accounts to dump money into.
Once every paycheck, you’ll call up your 401k provider and ask for an in-service withdrawal of your after-tax 401k into a roth IRA, with capital gains going to a traditional IRA. It’s unlikely, but ask if they can automatically convert your after-tax moving forward.
Beware: The customer service rep might not know what you’re talking about. Just politely explain that roth and after-tax are different things and ask for a different rep.
Beware II: Your employer plan might have an after-tax 401k but not in-service withdrawals of your after-tax 401k. If they mention “in-plan conversions” they are talking about after-tax 401k → roth 401k, which is inferior. Call ahead and check.
There’s an additional catch with the mega backdoor that also applies to the regular backdoor roth IRA: you must wait 5 years to withdraw contributions.
Withdrawals
With regular IRA contributions (where your income is below the phase out threshold of $73,000), you can withdraw your contributions without a penalty.
With the regular and mega backdoor methods, you need to wait 5 years after you transfer the money from your 401k for it to "season" (or whatever jargon they use) before you can withdraw it without penalty. This is called the 5-year rule.
Considerations for young professionals
You CAN withdraw contributions out of your roth IRAs early penalty-free. But once you contribute via 401k rollover, backdoor, or mega backdoor, then you have to wait five years before you can withdraw those contributions.
Most people advocate never ever taking money out of your retirement accounts. But if you understand the (very limited) withdrawal exceptions, this lets you over-contribute and then withdraw later if you need to, like a tax-free investment account.
IRAs have a lengthy list of exemptions that you can withdraw money from penalty free, including education expenses. 401k providers are not required to allow withdrawals for these same exceptions.
Structured payment plans are also an option to withdraw from 401k/IRAs penalty-free for early retirement, but once this switch is pulled you are not allowed to stop until 59.5.
If you work at a startup or small company, chances are you won't even have the option to invest in an after tax 401k.
IRA providers like M1 finance let you invest in stock markets for free just like how you would with Robinhood, minus the options trading.
You might want to invest in other asset classes like physical bullion. You can still do this via self directed IRAs but it's more complicated (and expensive) than just buying shit online when you get a custodian involved.
Tax advantaged accounts and retirement plans may not be right for you. Stocks markets are riskier than what most people think, even riskier than what most certified financial planners will tell you. See my previous post for examples of this.
You might be better off using that $43,500 mega backdoor contribution to fund your own business idea and potentially 10x your money instead of 1.1x-ing it. Or perhaps fund a down payment. Think wisely.