Mega Backdoor Roth, Part One: A Primer on Non-Roth After-Tax Contributions
Mega Backdoor Roth strategies have been in the news (not to mention Congress) a lot lately. In Part One of my Mega Backdoor overview, I review what they are, how they work, and how they differ from other retirement account strategies.
Thanks to venture capitalist Peter Thiel, best known for early investments in Paypal and Facebook, backdoor Roth IRA strategies have come under fire. Back in 1999, Thiel shrewdly placed private equity into a Roth IRA. Since then, the contributions have grown to $5 billion. Under current law, all $5 billion is shielded from taxes for the remainder of Thiel’s life.
But recently, House Democrats proposed legislation that would close this loophole. Many financial advisors — myself included — expect the legislation to pass, especially since it would raise roughly $749 million in its first decade (according to Wall Street Journal estimates). For now, however, backdoor Roth strategies remain in place.
There’s a lot of information out there about what I like to call the “Original” Backdoor Roth IRA, but that strategy is limited to $6,000 a year ($7,000 for those over age 50). This article will focus on a lesser known type of backdoor Roth strategy through the use of “after-tax” contributions to an employer sponsored 401(k) plan.
Many people think there are only two 401(k) contribution types: Pre-Tax and Roth. But some 401(k) plans offer a third option to make “after-tax” contributions — I like to refer to these as “NRATs,” short for Non-Roth After-Tax contributions.
Another common misconception is that you can only contribute $19,500 to your 401(k). While that’s usually the case, certain companies give you the option to exceed this limit through NRATs — sometimes by tens of thousands of dollars. Given its scale, this is often referred to as the Mega Backdoor Roth strategy.
You may not be a Thiel-style venture capitalist. But if your company’s 401(k) plan offers NRATs, you’re in luck. Under the right circumstances, making NRAT contributions can be extraordinarily beneficial. I’ve seen this option offered at a variety of companies*, but it’s most common at large tech companies. If you have some extra cash to put away, you should examine this option sooner rather than later. If it’s right for you, take advantage while you can.
Like most arcane financial topics, backdoor Roth strategies are tricky to understand. Even though they offer tremendous upside for many, not everyone who can use them should use them. If this article leaves you with questions, just send me an email, or set up some time to chat.
*Just because you don’t work in Silicon Valley, don't assume this door is closed to you. In addition to tech folks, I’ve helped professionals at large retail companies and BigLaw associates take advantage of this strategy.
What are NRATs?
Before we dive into NRATs, let’s review 401(k) contribution types more broadly. Employer 401(k) plans permit three main types of contributions:
Traditional “Pre-Tax” Contributions (Always Offered). Traditional pre-tax contributions are taken out of your paycheck without deducting federal or state income taxes. Instead, the IRS taxes the money when you take withdrawals in retirement. Pre-tax contributions are most advantageous when you’re in a high tax bracket today, but expect to be in a lower tax bracket in retirement, meaning you’ll pay less if you pay the taxes later. Many who live in states with high state and local taxes (e.g. New York, California) tend to prefer Traditional contributions.
Roth Contributions, or “Pure Roth” (Usually Offered). Unlike pre-tax contributions, Roth contributions are taxed upfront, and all future growth can be withdrawn tax-free (under current law, and assuming you meet the withdrawal criteria). To avoid confusion with NRATs, I like to refer to Roth 401(k) contributions as “Pure Roth” because from the moment you make the contribution, all subsequent earnings are tax-free. If you think your tax rate will be higher in retirement, it’s better to pay the taxes today. Plus, many people prefer the peace of mind that comes with getting taxes out of the way. If you live in a state without income taxes (e.g. Texas, Florida), I’m more likely to recommend Roth — especially if you expect to move in the future.
As of 2021, any combination of Traditional Pre-Tax (1) and “Pure Roth” (2) contributions by an employee is limited to $19,500 a year ($26,000 for those age 50 and over). If your employer provides matching contributions, they are treated as Traditional Pre-Tax dollars and don’t count toward the $19,500 limit.
Non-Roth After-Tax “NRAT” Contributions (Sometimes Offered). Here, we come to the main event. With NRATs, individuals can make 401(k) contributions beyond the usual $19,500 limit (up to $58,000 total, taking into account your contributions and your employer’s matching contributions). I like to think of the NRAT as a hybrid of Traditional and Roth contributions. NRAT contributions can eventually be withdrawn tax-free (like a Roth), but as long as these dollars remain classified as “after-tax,” any earnings on these dollars will be subject to ordinary income tax upon withdrawal (like a Traditional).
Under certain circumstances, Mega Backdoor Roth strategies present a way around this latter income tax. If you “purify” (my term) these dollars, they are re-categorized as “Pure Roth,” and like Thiel’s investments, grow tax-free, forever. More on that below.
To clarify:
Traditional pre-tax contributions (and attributable earnings) are not taxed now, but will be taxed upon withdrawal in retirement.
“Pure” Roth contributions are taxed now, and never again (under current laws).
NRATs allow individuals to exceed the usual $19,500 contribution limit and are taxed at the time of deposit. While the contributions (or basis) will always be tax-free, earnings are subject to ordinary income tax unless you “purify” NRAT contributions, effectively converting them to “Pure Roth.” Fortunately, many of you can do that.
If you’re feeling fatigued by this point and just want the answers, send me your 401(k) Summary Plan Description (SPD) or schedule a call with me. If you want a deeper dive with examples, keep reading!
How do I “purify” my NRAT contributions?
Just how beneficial NRATs are depends on how flexible your employer’s 401(k) plan is. You can find the details of your company’s plan in your “401(k) Plan Document” or “Summary Plan Description” (SPD). Note that some companies don’t allow NRATs at all, and others will place limits on the frequency and/or dollar amounts each year.
1) In-Plan Roth Conversion — Funds Remain in Your 401(k)
Inquire if your plan offers an “in-plan Roth conversion” feature. If you’re lucky, it might even have an automatic in-plan Roth conversion feature. With an in-plan Roth conversion, the funds remains within your 401(k) but the after-tax “NRAT” contributions are reclassified as Roth 401(k). You will continue to receive a single account statement, with a breakdown of your contribution types (Pre-Tax, Roth, After-Tax).
2) In-Service Withdrawal — Transfer Funds Out of Your 401(k) into a Roth IRA
This is the rarer of the two, but not uncommon within certain industries. Your plan may allow you to request an in-service withdrawal (sometimes called an in-service distribution) and transfer the NRAT contributions to a Roth IRA while still employed with the company. In this case, your after-tax “NRAT” contributions are withdrawn from your employer’s 401(k) plan and moved to a Roth IRA unaffiliated with your employer. You will receive a separate statement and can even use a different institution if you’d like. For example, your 401(k) may be held with Fidelity but you could open the Roth IRA at Vanguard or Schwab.
What if my plan offers NRAT contributions but they prohibit in-plan Roth conversions and non-hardship in-service withdrawals?
If your plan does not allow non-hardship in-service withdrawals or in-plan Roth conversions, the decision to make NRAT contributions for a Mega Backdoor Roth strategy becomes more complex.
The right decision depends on how long you plan on staying with the company. If you plan on changing jobs or retiring fairly soon, your money can be “purified” sooner. On the other hand, if you love the company you work for and you plan to stay there throughout the balance of your career, you might be better off investing the money outside of a retirement account. Why? Because the growth will be subject to capital gains taxes instead of ordinary income taxes, and it will be more easily accessible (i.e. you can use it before retirement).
It’s also worth noting that there are some instances where you may be better off keeping the money inside the 401(k) plan even after you depart. Again, it’s highly specific to your situation.
How do I know if NRATs are right for me?
In Part II, I’ll dive into who can and should use NRATs, including a couple of case studies based on real situations.
This is a very complex topic. If you’re feeling overwhelmed, that’s completely natural. My job is helping successful professionals like you make sense of the acronyms and regulations in light of your personal circumstances. I invite you to read on, or if you’d like to discuss your situation with me over the phone, set up some time to talk.
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