There's a lesser known sibling of the commonly used backdoor Roth which allows for an additional $38,500 which can be added to your Roth account per year. The Mega Backdoor Roth lets you make the maximum contribution by taking full advantage of the tax codes.
Not all employer plans support Mega Backdoor Roth. Only 10% of Vanguard's plans do. If you have one of these plans then consider yourself fortunate.
There are a number of contribution limits for retirement accounts. Let's start with the most common limits that people are familiar with.
|IRA Contribution Limit||$6,000||Roth IRA contributions are not allowed if your AGI (annual gross income) is above the following.
|401(k) Pre-tax Limit||$19,500||Employer match does not count towards limit.|
|401(k) Defined Contribution Limit||$58,000||Includes all contributions to your 401(k) plan including employer match.|
The highlighted row is what's used for the Mega Backdoor Roth.
Both IRA and 401(k) are great for retirement but have some key differences.
IRAs (Individual Retirement Account) are individually opened and managed. You can, and should, open one and start contributing early. There are two types of IRAs, traditional and Roth. Traditional IRAs are tax deductible and you pay tax on growth once you take money out. Roth IRAs are not tax deductible and you are able to take money out without paying taxes on the growth.
If your AGI is higher than listed in the table above then you are not allowed to make any contributions to your Roth IRA. This is where the more common backdoor Roth is used to circumvent this limit (in a legal and IRS-sanctioned manner).
401(k) plans are employer managed accounts and can be traditional (pre-tax) or Roth (post-tax). You cannot have a 401(k) plan if you're not employeed. If your employer provides a 401(k) plan then you can contribute up to $19,500 of pre-tax money. Many employers offer 401(k) contribution matches. You should contribute as much as you can towards the $19,500 but especially whatever is needed to get the company match.
There are 4 types of contributions which can be made to a 401(k) plan.
The sum of these must be less than $58,000.
Let's start with a basic example where there is no company match and you contribute the maximum $19,500. This leaves $38,500 remaining of the $58,000 limit.
$58,000 - $19,500 = $38,500
In a slightly more complicated example where your company matches $9,000 leaves you with $29,500 which can be contributed.
$58,000 - $19,500 - $9,000 = $29,500
You'll want to contribute as much as possible as a post-tax contribution. It's likely that your 401(k) will contain both pre and post tax contributions. Your plan should keep track which funds are which. Look for "source of contribution" to see the breakdown.
Growth on post-tax contributions are taxed but we can avoid that. In order to accomplish this by converting these funds to an IRA and diverting the pre-tax contributions to a traditional IRA and post-tax contributions to a Roth IRA. If you wait to do this you'll be taxed on any growth to your post-tax contributions.
By doing this you've effectively contributed up to $38,500 to your Roth IRA. This is in addition to the $6,000 you can contribute directly or using a regular backdoor contribution.
Once the money is in your Roth then it can grow completely tax free, contributions can be borrowed against, you won't have to take required minimum distributions and can leave the money to your spouse or children without a hefty tax bill.
All of those are great reasons to take advantage of the Mega Backdoor Roth.