What is a Mega Backdoor Roth? (MBDR)
There are lots of hidden gems in the employee benefits packages that companies offer, but one of the best is the ability to do a Mega Backdoor Roth (MBDR).
Properly utilizing an MBDR provides you with the opportunity to accrue hundreds of thousands of tax-free dollars at retirement. While the ability to do an MBDR doesn’t exist at every company, this valuable perk is becoming more common as a growing number of employees are demanding it.
Given the increase in MDBRs, we thought it’s a good opportunity to write an article explaining what an MBDR is, how it works, why it’s beneficial, and when you should consider doing an MBDR.
What is an MBDR?
A Mega Backdoor Roth refers to the ability to put extra money into a Roth account either within your 401(k) and/or Roth IRA.
This ability can prove particularly useful for people who already max out their Roth IRA, are ineligible to contribute to a Roth IRA, and/or are aggressive savers.
Use of the word “backdoor” may give the impression that it’s something sneaky or not allowed, but the use of the term really has more to do with the fact that it’s a roundabout way to get where you want to go. (Due to the way current laws are written.)
How Does an MBDR work?
To understand how an MBDR works, you will first need to understand that there are four types of contributions that can be made to a 401(k).
Employee Pre-tax Contributions
Employee Roth Contributions
Employer Contributions
Employee After-tax Contributions
The maximum that can be contributed to a 401(k) through Pre-tax or direct Roth Contributions is $23,000 for 2024.
The overall maximum contribution that can be made to a 401(k) is a nice $69,000.
We’ve provided two visuals (below) to help illustrate the difference in contribution methods to your 401(k):
Illustration #1 of MBDR Contribution Limit
Illustration #2 of MBDR Contribution Limit
After examining these graphics, you can see that if you max out your pre-tax/Roth contributions to your 401(k), there will still be $46,000 that can be contributed in either employer contributions or by you contributing after-tax dollars. This is where an MDBR becomes useful.
After-tax Contributions vs Roth Contributions
After-tax contributions and Roth contributions have different limits, but they also have different tax consequences.
After-tax contributions are similar to Roth contributions in the sense that you pay tax before the contribution is made, but the growth afterward is considered “tax-deferred.”
This means that someday when you pull from the after-tax piece of your 401(k), you’ll need to pay tax on any growth.
Contributions designated as Roth on the other hand, will grow “tax-free” and the distributions will also be tax-free.
This is why people love Roth assets. And the great news is that the MBDR process lets you take your After-tax assets and turn them into Roth assets.
Completing the MBDR Process
Theoretically, the MBDR process is pretty easy.
Step 1: Contribute after-tax dollars to your 401(k)
Step 2: Request a “Conversion” of your after-tax dollars to your Roth 401(k) or a Roth IRA
Obtaining Roth status can be as easy as this. Sometimes 401(k) providers will even let participants do it online and others will just automatically convert after-tax assets to Roth.
The problem is that every 401(k) plan is different and it’s sometimes hard to figure out what you’re actually able to do within your specific 401(k) plan.
Checking MBDR Roth Eligibility
In order to do an MBDR, you will need to first verify a few things:
That your 401(k) allows after-tax contributions
That you can either do an in-plan conversion to your Roth 401(k) or
That you’re able to move after-tax contributions to an outside Roth IRA (which is known as an in-service withdrawal)
You can check your company’s Slack and Team channels for resources, but the best place to figure out this information is to review your 401(k) provider’s Summary Plan Document (or some similar sounding name).
There is also usually a number you can call to talk to someone at the 401(k) provider company. Calling can be annoying, but (most often) we’ve found that they are very helpful.
Why and When Should I Do an MBDR?
We all know how important it is to save and invest for the future. And simply put, there aren’t many better places to put that money than in a Roth account.
The IRS limits on standard Roth IRAs are really low ($7,000 for 2024). But if you max out your MBDR abilities, you’re contributing several years' worth of Roth money all at once - thus the usage of the word “Mega.”
What may prove a bit more difficult is budgeting in a way that affords you the ability to max out your MBDR. Obviously, it’s awesome to save an extra $40k+ in Roth assets every year, but managing to do this can put a strain on your cash flow.
If maxing out your MBDR is too difficult, please remember that you’re not required to do the maximum contribution. If you have the ability to do an MBDR, you can take some time to adjust how much you’re contributing until you arrive at a savings rate that works best for you.
Final Thoughts on Doing an MBDR
We are huge fans of MBDRs and hope more companies begin to offer this benefit. We’re encouraged to see that even more traditional companies are starting to offer them (at least partially) in their 401(k) plans.
Since 401(k)s and Roth IRAs are retirement plans, it’s important to account for any large upcoming expenses you’re likely to have. Once money goes into retirement accounts, it can be difficult and sometimes costly to get that money out, so it’s best to treat the money going into them as a long-term investment.
An unfortunate fact is that many advisors don’t encourage MBDRs because it can lead to fewer assets being managed by them. If money is invested in a 401(k), it’s unlikely that an advisor will be able to charge on it. (This is one of the many reasons we are proud to be advice-only advisors.)
If you have any questions about saving for retirement or saving to become financially independent, please check out our services. We’re happy to help you achieve your financial goals. Thanks for reading!