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Investing Specialists

Heavy Savers, Meet the Mega-Backdoor Roth

Aftertax 401(k) contributions will beat taxable-account contributions, especially for contributors who can do in-plan conversions or in-service withdrawals.

“Wait--are you sure you can do that?”

That was my husband’s response to hearing about my plan to redeploy some of the contributions that we had been making into our taxable brokerage account each month into my 401(k) instead.

His skepticism was understandable. After all, I was already making contributions to my Roth 401(k) up to the IRS limits; in 2019, savers under age 50 can contribute $19,000 to their 401(k)s and $25,000 if they’re 50-plus.

But heavy savers may be able to get even more assets into their 401(k)s each year, above and beyond that baseline contribution limit. That’s because an even higher contribution limit applies to total 401(k) contributions. Total contributions consists of the employee’s own pretax or Roth contributions (to which the $19,000/$25,000 limits apply), employer contributions (matching funds and the like), and aftertax contributions. In 2019, the total 401(k) contribution limit is $56,000 if you’re under 50 and $62,000 if you’re 50-plus (or 100% of your compensation, whichever is less). That effectively triples the pretax/Roth contribution limit for people under 50, and more than doubles the employee contribution limit for people 50-plus.

Making additional aftertax contributions so that aggregate contributions hit that higher level--then periodically moving those aftertax assets into a Roth account--is what’s sometimes called a mega-backdoor Roth. And it’s a strategy that heavy savers would do well to consider, provided their plans allow it.

How It Works
Before we go any further, let’s review the two basic 401(k) contribution types: pretax and Roth. In the case of pretax (or "traditional") contributions, dollars go into the 401(k) without the employee paying taxes on them. The accountholder won’t owe any taxes on her gains as long as the money stays inside the account, but she’ll owe taxes on the whole amount when she withdraws it in retirement.

Roth 401(k) contributions experience the opposite tax treatment. The employee contributes aftertax dollars, then won’t owe any taxes on the money while it compounds or when she pulls the money out in retirement. Roth contributions are generally best for people who think their tax rate in retirement will be higher than it is at the time of contribution—for example, people who have hefty balances in traditional 401(k)s and IRAs, which are subject to required minimum distributions at age 70.5.

Aftertax contributions--the type that figure into the mega-backdoor Roth--aren’t as attractive as pretax or Roth contributions, at least not on a stand-alone basis. It might seem like they’d be just like Roth contributions, which also involve the contribution of funds that have already been taxed. But there’s a crucial difference: The earnings on Roth 401(k) contributions begin compounding tax-free as soon as the money is in the account. Meanwhile, to the extent that the aftertax contributions generate investment earnings inside the 401(k), those earnings compound on a tax-deferred--not tax-free--basis.

Thus, the name of the game with aftertax 401(k) contributions is getting that money into a Roth account as soon as possible, to limit the amount of investment earnings that will eventually be subject to tax. Investors can get those aftertax dollars into a Roth account expeditiously if their plans offer in-service withdrawals of aftertax contributions, whereby the aftertax dollars can be shunted into a Roth IRA outside the plan. (Some plans offer such withdrawals only in case of hardship; what you're looking is the ability to make withdrawals for nonhardship reasons.) Alternatively, some 401(k) plans offer what’s called an in-plan conversion, which allows employees to convert those aftertax contributions to Roth inside the plan.

If in-service withdrawals or in-plan conversions aren’t an option, the employee will have to wait until she’s left her employer or retired to roll over those aftertax contributions into a Roth IRA; the disadvantage of waiting is that taxes can rack up on the investing earnings in the meantime. (The investor would owe taxes on any investment earnings that have accrued before the assets were converted to Roth.) At the time of rollover, the investor can set up a Roth IRA for the aftertax contributions and a Traditional IRA for the investment earnings component. If the investment earnings piece is relatively small, the investor might choose to roll the whole amount into a Roth IRA, paying any taxes due on the investment-earnings piece at the time of the rollover/conversion. 

Aftertax Contributions > Taxable-Account Contributions
To illustrate the benefits of aftertax 401(k) contributions for high-income savers who are maxing out their other tax-sheltered vessels, let's look at an example. We'll assume 52-year-old Adam is maxing out all of the tax-sheltered options he can get his hands on, but he still has another $10,000 per year in aftertax dollars available to invest for the next 15 years prior to retirement. After that, he'll hold the account for another 15 years and then begin drawing from it. He earns a 5% annualized return over the 30-year period.

If he invested that $10,000 per year in a taxable account, we'd have to give his annual return a bit of a haircut to account for the fact that he's subject to dividend and capital gains taxes during his accumulation period. Assuming a modest tax-cost ratio of 0.5% annually, that takes the 5% annualized return down to 4.5%. At the end of the 30-year period, his total pot would have grown to $402,231. If he were to begin withdrawing the money after 30 years, he'd owe capital gains taxes on the $252,231 of the account that represents investment appreciation. (He won't be taxed on the $150,000 in contributions again, because he made them with aftertax money.) Assuming a 15% capital gains tax rate (and it would actually be a bit lower because he has paid some taxes already and will receive a step-up in his cost basis), he'd have an aftertax balance of $364,396 available after 30 years.

If Adam invested that same $10,000 in an aftertax 401(k) for 15 years, he'd earn the full 5% on his money. Because the account is tax-deferred, he's not having to pay taxes on her money as it grows. (Dividends and capital gains distributions aren't taxed on a year-by-year basis as long as the money stays inside the tax-deferred account.) He'd have nearly $216,000 in the aftertax 401(k) after the first 15 years. Let's assume he also retires at that point, at age 66. He could then take the $66,000 in investment gains and steer those funds to a traditional IRA. His $150,000 in contributions could go into a Roth IRA at that time. Assuming both accounts earned a 5% annualized return for the next 15 years, he'd have $448,601 on a pretax basis. Withdrawals from the Roth account, totaling $311,839, would be tax-free, but he'd owe ordinary income tax on the $136,762 traditional IRA that has never been taxed. Assuming a 22% tax rate on the traditional IRA, his take-home aftertax amount would be $418,514--more than $50,000 ahead of the taxable-account investor.

He really began cooking with gas in the account once he set up the Roth; the longer the money grows inside the Roth (that is, the sooner it's removed from the confines of the aftertax 401(k)), the greater the tax benefits. That means that if a plan allows regular in-service distributions or in-plan conversions (it's possible for the employee to regularly roll over aftertax amounts to Roth), the tax benefits of the aftertax 401(k) are greater. In addition, if he wanted to give the money to his heirs rather than spend it during his own lifetime, the tax benefits of the Roth would be magnified over that longer period.

Who Should Consider It?
The biggest factor in whether to make aftertax 401(k) contributions is whether the plan allows them. As the above example illustrates, aftertax 401(k) contributions will be the most advantageous for people who have access to a plan that offers a mechanism for periodic conversions to Roth, either through in-plan conversions or in-service withdrawals. In a similar vein, even employees without access to a plan with in-plan conversions or in-service distribution features may benefit from the aftertax contributions if they plan to leave their employer soon; that way, the aftertax assets can be rolled into a Roth IRA sooner.

In addition, if the aftertax assets will remain in the plan for any period of time (for example, because the plan allows for in-plan conversions but not in-service distributions), it’s essential that the plan be of good quality. That means low expenses, both at the fund and the administrative level, and a well-diversified menu of choices.

Who Should Avoid It?
On the flip side, some investors will find the aftertax 401(k) off limits simply because their plans don’t offer them. It’s also important to note that aftertax contributions will always be less advantageous than pretax or Roth contributions, either to an IRA or 401(k). Aftertax 401(k) contributions also pale alongside health savings account contributions when it comes to the two accounts’ tax merits. Thus, investors should only turn their gaze to aftertax 401(k) contributions after they’ve made the maximum contributions to those other vehicles first. Aftertax 401(k) contributions are best viewed as an alternative to making taxable account contributions--not making contributions to other tax-deferred vehicles. 

In addition, making aftertax 401(k) contributions isn’t advisable if the company retirement plan isn’t very good and there’s no in-service distribution feature that allows the employee to get the assets out of the plan and into a Roth IRA.

Finally, there are practical trade-offs to be weighed before contributing to an aftertax 401(k). One is simply whether you expect to need the money before retirement; the virtue of having the money in a taxable brokerage account rather than in the 401(k), even an aftertax one, is that the money can be pulled out of the brokerage account without any taxes or penalties. (Many plans allow in-service distributions of aftertax contributions, but they may also require that you take out earnings at the same time.)

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