If you’re a personal finance nut you may have heard of a strategy called the “back door Roth IRA conversion.” This maneuver essentially allows you to contribute money to a Roth IRA, even if your income is otherwise to high to make a direct contribution. You make a non-deductible contribution to a traditional IRA, convert those funds to a Roth IRA, and presto! You have cash in the Roth that won’t ever be taxed again. While it seems like this is a glaring loophole in the tax code, Congress has endorsed the strategy in a conference committee report from the Tax Cut & Jobs Act.
But as great as it is to take advantage of Roth IRAs while you’re in high tax brackets, you’re still limited to the annual IRA contribution maximums of $6,000 per year (or $7,000 if you’re 50 or older). The “Mega” back door Roth conversion is a similar strategy, but allows for up to $37,000 per year in additional Roth contributions using a 401(k) plan.
Why the “Mega” Back Door Roth Conversion Strategy Works
The Three Types of 401(k) Contributions
To start, let’s review the three types of contributions you could make to a 401(k) plan. The first is the most common: your employee deferrals. You can instruct your employee to defer funds from your paycheck and deposit them on your behalf into the company’s 401(k) plan. Some plans allow you to make these deferrals on a Roth basis, and the limit in 2019 is $19,000 per year.
The second type of contribution is an employer contribution. This is anything your employer puts into the plan on your behalf, and includes matching contributions, or contributions based on a percentage of your compensation or company profitability. It may be subject to a vesting schedule, and is always made on a pre-tax basis.
The third, and widely unknown type of contribution is an after-tax deferral. Some 401(k) plans allow you to make additional contributions beyond your employee deferral on an after-tax basis, once you’ve reached the $19,000 annual limit. Note here that 401(k) plans are not required to allow this feature, and not all do.
There are two limitations to annual 401(k) contributions. The first is the $19,000 limit on employee contributions ($25,000 if you’re over 50 years old). The second is on the total amount contributed to the plan on your behalf. This limit is $56,000 in 2019, and consists of the three contribution types listed above.
So, to determine how much you could contribute in after-tax deferrals, you’d need to subtract $19,000 (again, $25,000 if you’re over 50) and the total amount of your employer contributions from $56,000.
Theoretically you could make up $37,000 per year in additional Roth IRA contributions using this maneuver ($56,000 – $19,000). You’d need to be under 50 though, and you couldn’t receive any contributions from your employer.