At The Money: The Mega Backdoor Roth

401(k)s top out at $24,500, but you can boost your tax-deferred investments to as much as $80,000 by switching to an IRS-approved Mega Backdoor Roth account. Dan LaRosa is Director of Corporate Retirement Plans at Ritholtz Wealth Management, overseeing more than $400 million in various plans. He is a Qualified Plan Financial Consultant (QPFC) and Accredited Investment Fiduciary (AIF) and partner at the firm. Each week, “At the Money” discusses an important topic in money management. From portfolio construction to taxes and cutting down on fees, join Barry Ritholtz to learn the best ways to put your money to work. See omnystudio.com/listener https://omnystudio.com/listener for privacy information.

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• 3:09Barry Ritholtz?

  Tax-deferred portfolios, also known as qualified accounts, have become one of the most popular ways to invest. There are about 100 million households, nearly 75% of every household in America, with some sort of a formal tax-advantaged retirement savings. Total defined contributions are nearly $14 trillion. The latest addition in your tax-deferred portfolio choices is the mega backdoor Roth. To help us unpack all of this and what it means for your retirement savings, let's bring in Dan LaRosa. He's an expert in qualified retirement accounts and works with clients all over the country. In full disclosure,

• 3:52Barry Ritholtz?

  Dan leads the corporate retirement plans at my firm, Ritholtz Wealth Management, and is one of my partners. So let's start with the basics. Most of our listeners are certainly familiar with 401Ks, and they're probably familiar with variations such as a Roth 401K or a Roth IRA. What is a mega backdoor Roth?

• 4:15Speaker 05

  So a regular 401k allows you to contribute up to $24,500 into it, right? The mega backdoor Roth feature just allows you to contribute above and beyond that $24,500 up to potentially $72,000. So it uses the same type of strategy that you have in your regular backdoor Roth IRA, right? That's just a way for high earners to get money into a Roth account. They're going to make a non-deductible contribution to a traditional IRA and then convert that to a Roth IRA. It works, it's great, but the dollar amount is pretty small, right? It's $7,500.

• 4:55Speaker 05

  The mega backdoor Roth uses the same strategy, but inside of your 401k plan where the contribution limits are significantly higher.

• 5:06Barry Ritholtz?

  So mega backdoor 401k Roth, sounds kind of complicated, but it really seems like that's a huge increase in your after-tax contributions that theoretically grow tax-free and are withdrawn tax-free, is that right?

• 5:26Speaker 05

  That's right. It's a cheat. When it works and your plan allows it, it's a cheat code, right? There's nothing else out there that's going to allow you to get that much money into a qualified, that many, that much Roth dollars into a qualified retirement account.

• 5:41Barry Ritholtz?

  So cheat codes and backdoors, sounds a little shady. Is this legit with the IRS? Have they blessed this?

• 5:49Speaker 05

  Yeah, yeah. It's just the backdoor part that sounds kind of sketchy. It is, it is not a gray area. It is not a loophole. It's completely legit. The rules are actually very much clear. The real challenge is just whether or not your plan allows you to use it.

• 6:04Barry Ritholtz?

  So, so let's go through that. If the IRS says it's kosher, I would imagine your employer or the benefits provider, maybe even the custodian, who, who has to sign off on it? Is, is it any of the above or all of the above? Who's, whose approval is required?

• 6:22Speaker 05

  Yeah, it's there's really nothing to do with the custodian with this. It's more of a plan level decision that's going to be made by the employer, right? They're the ones that are going to control the plan design and would ultimately make the decision to offer the after-tax contributions in plan Roth conversion features that make up this mega backdoor Roth. The 401k provider is obviously involved and they need to be able to administer this, but that's generally not a problem.

• 6:50Barry Ritholtz?

  So typically 24 and a half, 24.5 is a regular 401k. I'm assuming catch-ups and things like that are separate. So if you could go to 72,000 in this and it's after-tax, why would the employer object? This sounds like a great deal for anyone who wants to throw more money into their 401k.

• 7:15Speaker 05

  Yeah, and this feature has gotten a lot more popular in recent years, but the reality is the most likely answer to why more plans don't do it, it just doesn't work for every plan. After-tax contributions and the in-plan Roth conversions do add some complexity to the plan design. And most importantly, they trigger additional compliance testing and that extra compliance testing, if failed, can prevent the whole strategy from working well together.

• 7:43Barry Ritholtz?

  So I know our plan in our shop offers this in-house and I've been taking advantage of it personally. So I'm thinking about other service companies, lawyers, accountants, advisors, architects, anybody that's, you know, a white collar office with reasonable salaries. It would seem that this should be something that all those people should take advantage of. Why don't all of these sort of firms take advantage of it? It sounds like, hey, 72,000 is triple what you're normally allowed. That's 72,000 above what

• 8:25Barry Ritholtz?

  your traditional 401k is giving. Why wouldn't everybody jump on this?

• 8:31Speaker 05

  Yeah, well, 72,000 is actually the total. That's your all-in that each individual can get into each plan. But why don't more plans or companies use this feature? Again, it just doesn't always work. So without getting too deep into the weeds on the compliance testing side.

• 8:51Speaker 05

  If the only individuals that are interested in using this feature and contributing, making these after-tax contributions are the owners and highest wage earners, it's not going to work. It's as simple as that. So the company either has to be big enough or have enough wage earners where it's just not the top 20% or so using it in order for it to work.

• 9:15Barry Ritholtz?

  So what does it typically look like in a firm that does this? What sort of buy-ins do you need from management as well as the rest of the staff or partnership?

• 9:25Speaker 05

  Yeah, I mean, listen, as far as buy-in from the staff, if you have a lot of employees that are contributing and maxing out, right? If you have a lot of people that are maxing their contributions and would do more if they could, that's one good sign, right? It's worth looking into in that situation. But you'll also have to have enough highly compensated individuals, right? If you just have, if you have 30 people and eight of them are the big wage earners, it's just, again, it's not going to work. It's going to be top-heavy. So if you have enough highly compensated individuals that are interested in using this feature, there's a good shot it'll work.

• 10:02Barry Ritholtz?

  So I immediately thought of professional services companies, financial advisors, attorneys, accountants, bankers, doctors, et cetera. But, you know, what sort of industries do you see use this? What sort of businesses is this really well-suited for?

• 10:19Speaker 05

  All the professionals that you just listed, tech companies, I mean, I'd say just about all of the big tech companies have this feature available. Again, I think any industry or any company where a large percentage of the population would be considered high wage earners, meaning say over $150,000, $160,000 a year, and that are interested in making these significant contributions, it could work.

• 10:45Barry Ritholtz?

  So let's assume you have a traditional 401k and everybody is maxing out their 24.5 plus whatever catch up over 50 is out there and they want to be able to save more money. What is the process like converting that to a mega backdoor Roth? Walk us through that that process.

• 11:06Speaker 05

  Yeah, ultimately, it's going to have to come from the employer, right? So whoever at the company is in charge of of running and administering the 401k will need to be involved in that decision. You know, if if you're an influential employee, of course, you can try and influence and push on that decision. But ultimately, the the plan sponsor or the employer will work with the 401k provider to update the plan documents, add a couple of features. For the mega backdoor Roth to work, a plan has to allow two things. The first is the ability to make after-tax contributions. And the second is a way to move those after-tax dollars into a Roth account. Moving the after-tax dollars into Roth can happen one of two ways.

• 11:52Speaker 05

  First, you have an in-plan Roth conversion where the after-tax dollars are converted to Roth and stay in the 401k plan. And the second is an in-service distribution where the after-tax dollars are rolled into an outside Roth IRA. In-plan Roth conversion is probably more common. It's just simpler to execute and it keeps all the money inside the plan.

• 12:17Barry Ritholtz?

  Huh. I mean, this is really attractive. I'm assuming someone reaches out to HR or one of the managing directors or partners or whatever the title is and says, hey, this is a great opportunity. Why don't we do this? Is there like an extra cost? What? Why would there be any reluctance to do this, assuming it's the right sort of mix of high-wage employees?

• 12:43Speaker 05

  Yeah, there is no additional costs. You could say there's a little bit of an additional headache, right? Again, you're adding more complexity, another layer of compliance testing. So whoever, you know, is in charge of administering the 401k to the company, yeah, maybe it amounts to a little more work, but when it works, it works really well and the significant benefits far outweigh, you know, the minor administrative, additional administrative burden.

• 13:10Barry Ritholtz?

  So we're talking about companies with partners and HR, et cetera. What about either a solo practitioner or a 1099 contractor? Can you do this sort of mega backdoor Roth if you're self-employed?

• 13:25Speaker 05

  Yes, absolutely. Mega backdoor Roth works perfectly for solo or owner only 401k plans. There are no compliance tests and headaches or administrative burdens when the plan only covers owners. So yes, we are huge fans of the mega backdoor Roth in solo 401ks.

• 13:43Barry Ritholtz?

  So let's talk about timing. How does this work? How much are people converting? You know, what does this look like in terms of best practices? Either daily or each pay period or quarterly? How often does this occur?

• 13:57Speaker 05

  It really depends on the plan or on the plan provider. Some plans only allow a certain number of conversions or distributions each year, which is obviously not ideal. And it really kind of pushes the burden onto the participant to figure out when and how to do that. Others have daily automatic Roth conversions, which is just awesome. I've done it both ways, right? I've had the once a year manual paper form after tax conversions. And we now have the daily automatic Roth conversions with Fidelity and it's a game changer. It's great.

• 14:38Speaker 05

  As an employee, you don't have too much control over that. It really depends on the provider. But whatever the case, I certainly recommend reaching out to your 401k provider. The first time you do this, the first time you convert and making sure you get it right. Do it the right way.

• 14:54Barry Ritholtz?

  So you and I have talked about this in the past and you discussed automatic Roth sweeps. Is that something that again gets set up by the provider or the employer or the employee? How do you make sure that each payroll period? Or in the event of any distribution or yield or dividend? How do you make sure that stays on the Roth side?

• 15:18Speaker 05

  Yeah, it's a great point. So that daily automatic Roth sweep or automatic Roth conversion is awesome, but only some record keepers, only some providers offer it. Right? So, so the answer, as it, as it usually is with these types of plans is it depends, right? Every plan is different. Every provider is different.

• 15:38Speaker 05

  If your plan does offer it, or if you're not sure, reach out to the 401k provider. If your plan does offer it, the employee generally has to activate this daily automatic Roth conversion feature.

• 15:50Barry Ritholtz?

  All right. So I know my 401k is at Fidelity, all of these daily sweeps and other things that, you know, from my perspective, it was set and forget. I don't have to pay much attention to it. What about some of the other big 401k providers? Schwab, Vanguard? Is it, is it possible to do it with those? And do they allow for these daily sweeps? Like, what's the landscape look like out there?

• 16:16Speaker 05

  Yeah, as this feature has gotten more and more popular in recent years, which it certainly has, more providers are getting better at it. Right? Five years ago, I don't know if anyone outside of Fidelity did it. Now, certainly if your plan is big enough, you can pretty, they'll pretty much do whatever you want for it. I think Fidelity just happened to be the, the first one that was really good at administering it. But other providers are catching up quickly.

• 16:43Barry Ritholtz?

  Last question. People hear this described as tax-free growth forever. And obviously, that gets people excited. But what are the risks? What scenarios does this not make any sense? Where are you just better off investing in a taxable account?

• 17:00Speaker 05

  Yeah, I, I think the excitement is warranted. I'm a huge fan of the mega backdoor Roth feature. If your plan offers it and you can afford the extra contributions, my answer is usually do it. Just keep in mind a couple of things. First, if you use that in plan Roth conversion, the money stays in the plan and then follows the Roth 401k rules. All right? So that means you generally can't access that money until age 59 and a half or distributable event. So I think the biggest thing to answer your question, when does a taxable account make more sense? If present day liquidity is important.

• 17:37Barry Ritholtz?

  What about mega backdoor Roths? Is there the same required minimum withdrawal requirements?

• 17:46Speaker 05

  Actually, I think effective last year, the Secure 2.0 removed the RMD requirement from Roth 401ks. So there are no RMD requirements for a Roth 401k.

• 17:58Barry Ritholtz?

  Really interesting. So if you're working in a firm, or if you're a solo practitioner, and you're making a decent amount of money, but you want to save more for retirement, the mega backdoor Roth allows you to use after-tax dollars up to $72,000 to put into this account that will not only grow tax-free, but you can withdraw it tax-free whenever you want, after age 59 and a half, with no minimum requirements when you turn 73. It sounds like a great opportunity, and a lot of people just are unaware of it and are not taking advantage of it.

• 18:38Barry Ritholtz?

  You should look into this if you're in those circumstances and you have an employer who will work with you to create a banner corporate retirement plan. I'm Barry Ritholtz, you're listening to At the Money.

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