You may have heard about the Mega-Backdoor Roth 401(k), but how do you do it? And why does it matter to you? This strategy allows you to maximize your 401(k) contributions for tax-free income in retirement. Now how does it work...
- Elect to make maximum contribution to your company’s 401(k) by contributing to either Roth 401(k) or Traditional 401(k). As of 2021, the maximum you can contribute to your 401(k) if you are under the age of 50 is $19,500. If you are age 50 or over, you can make an additional “catch-up” contribution of $5,500 for a total of $25,000. NOTE, income limits do not apply to Roth 401(k) contribution as they do with Roth IRAs.
- Elect to make maximum contributions to “Additional After-Tax 401(k)” inside your company’s retirement plan. The maximum total contributions (including your Roth or Traditional contributions, employer match, and After-Tax contributions) to your 401(k) plan is $58,000 in 2021.
- Convert the “Additional After-Tax 401(k)” contributions to Roth. Some companies will allow you to do this automatically; others require a manual submission online; still others require a paper form to be submitted. Contact your employer’s plan to confirm your company’s requirements.
Now, why does this matter? Here is an example.
40-year old employee elects to make maximum contributions to their Roth 401(k) $19,500
Their employer matches 6% of the employees $200,000 W-2 income $12,500
The employee elects to make an additional After-Tax contribution $26,500
Total 401(k) Contributions (maximum allowed by IRS for 2021) $58,000
How does this compare?
Let’s assume that instead of contributing $46,000 to your employer’s 401(k) plan, let’s imagine you put the same amount in a non-qualified investment account. Assuming a 6% annual return for 30-years, your non-qualified investment account would grow to $264,200 with $218,200 of unrealized capital gains. In California, you could incur as much as a 38% capital gains tax at the highest rates, equal to a $82,916 tax bill. Furthermore, if President Biden’s proposal passes and top capital gains rates in California increase to 57.6%, you would incur a $125,683 tax bill.
How does this impact your investment portfolio?
Using this same example of $46,000 invested in your Roth 401(k) versus a non-qualified investment account, your retirement income picture is drastically changed. Assuming the same 6% return over 30-years, your Roth 401(k) would have a pool of $264,200 to take tax-free income from. Compare this to the non-qualified investment account, after paying taxes on capital gains, you would have a pool of $181,284 to take income from. Under President Biden’s proposal, you would have $138,517.
What does this look like after paying taxes?
Let’s assume you pay all your capital gain taxes at year 30 and reinvest the remaining at a 6% annual return. The value gap of your investment in the Roth account versus a non-qualified account is stunning. After 20 more years, you have an additional $265,000 in your Roth account compared to a non-qualified account. Under the President Biden’s proposal, you would have an additional $403,000 in your Roth account when compared to a non-qualified account. Now let’s not forget that any growth in the non-qualified account will generate additional capital gains tax, whereas the Roth account is tax-free.
Proactive planning matters. The Mega-Backdoor Roth 401(k) strategy can be very powerful, are you utilizing it for your retirement planning? Give us a call, we’re happy to help.