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Mega Backdoor Roth IRA: Step-by-Step Setup with Fidelity

You’re probably familiar with traditional IRA’s and Roth IRA’s. You have a 401(k) with employer matching. If you’re a high income earner, you have probably heard of a backdoor Roth IRA, since income limits prevent you from contributing to a Roth if you’re income is high enough. But what is a mega backdoor IRA? What are the advantages of this? How do you set one up? And do you want to? We’ll tackle all your questions on the mega back door Roth IRA.

Roth IRA’s and Backdoor Roth IRA’s

A Roth IRA has certain advantages. Since you contribute to the account with post-tax dollars, the money you withdraw is tax-free. This includes the gains made on the investments. Also, there are no required minimum distributions (RMD) for a Roth, and there’s no penalty for withdrawing the money whenever you want it, providing you’ve held the account for at least five years.

>>MORE: Roth IRA: Everything You Need To Know

>>MORE: Best 10 Firms to Open a Roth IRA Account

Back door IRA’s exist because of people who make over a certain income are not allowed to contribute to a Roth. There’s no rule on converting a traditional IRA to a Roth, however, so many people who earn high incomes take advantage of this “back door” strategy to open a Roth IRA. Okay. So, what’s a mega back door Roth IRA?

>>MORE: Backdoor Roth IRA: Step-by-step with Vanguard

What is Mega Backdoor Roth IRA?

If you have a 401(k) retirement plan that allows after-tax contributions, you may be able to open a mega backdoor Roth. The limit on 401(k) contributions, for tax-deductible benefits, for 2020 is $19,500, or $26,000 if you’re over 50. Many employers will match funds to contribute to a 401(k) as well. The employers matching contributions doesn’t count as your personal contribution. The total amount you can contribute to a 401K, both tax-deductible and after tax together, is $57,000. If you put in $19,500 and your employer contributes $10,000, you should be able to contribute $27,500 in after-tax contributions. Not every employer allows after tax contributions, so be sure to ask. Your 401(k) must also allow in-service withdrawals (i.e. you can withdraw the money in your 401(k) while you’re still working for your company).

Basically, the mega backdoor Roth IRA is just like a backdoor Roth, but since you can use 401(k) funds, the amount is a lot more. Also, since you contributed to the 401(k) with after-tax contributions, you won’t pay income taxes when you convert. You will have to pay Social Security and Medicare taxes, though.

>>MORE: Retirement Saving Strategies for High Income Earners

>>MORE: How Much Savings is Required to Retire at Age 55?

How do I Convert to a Mega Backdoor Roth IRA? Step-by-Step Example with Fidelity

This can be a little tricky. First of all, many employers don’t allow after-tax contributions to a 401(k) AND in-service withdrawals. The number is pretty small, but if you can, here’s how you can convert.

  1. Figure out how much your employer contributes to your 401(k)
  2. Subtract that from $57,000
  3. Now figure out how much you contributed before taxes and subtract that from $57,000
  4. This is the amount you can contribute in after-tax contributions
  5. Elect to do these after-tax contributions from your salary. Ordinary income tax rates and employment taxes will apply.
  6. If your employer offers a Roth 401(k), just do an in-plan rollover and your done.
  7. If not, do a trustee-to-trustee transfer of the after-tax 401(k) to a Roth 401K

If your 401K account is with Fidelity and your employer allows after-tax contribution to your 401K. You can definitely pursue this.

  1. Select the % of your salary for after-tax contribution on Fidelity app or website
  2. Contact Fidelity and ask them to set it up so that as soon as your after-tax money hits your 401K, it will roll over automatically to the Roth 401K that Fidelity offers. They call this in-plan conversion to Roth 401K
  3. Now you have both before-tax contribution to your traditional 401K and after-tax contribution to your Roth 401K. You can choose to invest in the same funds or different funds available in your 401K plan
  4. When you leave your current employer, you can select to roll your Roth 401K over to Roth IRA at Fidelity or another brokerage firm. There are usually more fund options to invest in a Roth IRA account than in a Roth 401K account.

You need to do the step #4 above since Fidelity doesn’t support automatic rollover of after-tax contribution to Roth IRA account. If you want to do this in step #2 above, instead of Roth 401K, you have to call Fidelity to have them move after-tax contribution money in your 401K to a Roth IRA account each time. This will be extremely time-consuming and complicated. We wouldn’t recommend it.

What you want to do is get as much money into the Roth account as possible because that will allow you to enjoy tax-free growth on the investments.

Obviously, you have to have the income for this to work. Not everyone can contribute lots of after-tax money to their 401(k). There’s also something called nondiscrimination testing for highly compensated employees that you’ll need to be aware of.

For most people, you should max out all of your other accounts before considering a mega backdoor IRA. If you’re below the income limits for a Roth, it’s a lot easier to just open a Roth and max it out because a mega backdoor Roth can be complex, with lots of little tax rules that can wipe out your tax advantages if you violate them. A mega back door Roth IRA is for people who maxed out their 401(k) and IRA accounts already and still have money to invest for their retirement.

>>MORE: Self-Directed Roth IRA: Its Pros and Cons. How Is It Different from Traditional Roth IRA?

>>MORE: Best Firms to Open a Self-Directed Roth IRA Account

Strategies for People Who Can’t Do a Mega Backdoor Roth IRA

If a mega backdoor Roth is unavailable to you, you have options:

  • See if your employer offers a Roth 401(k)
  • If you’re under the income limits, open a Roth
  • If you’re over the income limits, open a backdoor Roth
  • Invest in an indexed Universal life insurance policy

Not everyone can do a mega backdoor Roth IRA, and that’s okay. There’s still plenty of tax-advantaged places you can put your money. Consider a IUL policy, where you’ll enjoy tax-free growth and withdrawals into retirement as well.

>>MORE: Understanding Indexed Universal Life Insurance: Why is It a Good Option for Retirement Savings?

Ed Slott – a renowned tax expert – on tax benefits of IUL policies

Compare quotes of 30+ IUL products

Last Thoughts

While it can work for some high-income people, a mega backdoor Roth IRA is a bit complex. If you’ve already maxed out your 401(k) contributions and you’re interested, consult with a financial professional so that you don’t penalize yourself by violating tax-rules you were unaware of. Consider other investments if you can’t do a mega backdoor Roth. Funding your retirement can still be accomplished in any number of other ways.

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