Roth IRA’s are powerful investment accounts that allow you to invest after-tax dollars to earn money tax-free. You can contribute to a Roth IRA for as long as you live and you can easily pass them down to your children. You are not even forced to use it since there are no minimum required distributions. The only downsides are the annual contribution limits and the income limits. The annual contribution limit is $6000 ($7000 if over age 50). If you are filing single and your modified adjusted gross income is more than $139,999.99 per year, or if you are married filing jointly and your modified adjusted gross income is more than $207,999.99 per year, you can no longer contribute to a Roth IRA. There is a legal way around both the contribution limits and the income limits through the Mega Backdoor Roth Conversion.
As of now, my employer gives me 2% and matches 6% on my 401k contributions. As of 2021, you are allowed to contribute up to $19,500 per year ($26k if over 50) in your 401k plan. This contribution limit is much higher than that of the Roth IRA. My plan with Fidelity allows me to contribute after-tax dollars into my 401k. This differs from the after-tax dollars in a Roth IRA because a Roth IRA grows tax free while 401k earnings are always taxed. Not all plans allow this, however my plan allows me to rollover ONLY the after-tax 401k contributions if I wanted to. Other plans may require you to rollover both the pre-tax and after-tax together.
Two Ways to Rollover Your Funds
Rollovers do not count towards the contribution limits of your accounts. There are two ways I can rollover money into a Roth IRA through the mega backdoor Roth conversion.
- Immediate Rollovers into Roth IRA – If I decide to contribute 10% after-tax dollars into my 401k, I can rollover the full 10% contribution into my Roth IRA on the day I receive my paycheck. This allows me to minimize or eliminate the need to pay taxes on my earnings. If I wait a day or a week then my contributions would have likely earned some pre-tax money. Fidelity makes this rollover strategy easy with their app.
- Tax-Deferred Rollover into Traditional AND Roth IRA – I can choose to rollover my after-tax 401k contributions into a Roth IRA, then rollover my 401k pre-tax earnings into my Traditional IRA account where everything is already pre-tax.
While I have several investment accounts (401k, Roth IRA’s, 529, HSA’s, Individual), I don’t actually have a Traditional IRA account. I don’t make enough money to regularly contribute to one since I am contributing to many other accounts. I decided to go with option 1 and rollover into a Roth IRA on the same day I receive my paycheck. In just three steps, here is how the rollover process went from my Fidelity 401k to my Betterment Roth IRA.
Step 1:
I called Fidelity to verify that my employer allows after-tax Roth 401k contributions and that I can rollover my after-tax contribution whenever I want, as many times I want. Once this was confirmed, I went on to step 2.
Step 2:
Log into your account and change your contributions so that you contribute a percentage to your Roth 401k. I kept my pre-tax contribution the same but added 2% to my after-tax contribution.
Step 3:
I waited until I received my paycheck at the end of the month to see how much was transferred to my after-tax Roth 401k, then I logged into the app and proceeded to rollover the money from my Roth 401k to my Betterment Roth IRA. The process of rolling over money is easy through the Fidelity NetBenefits app. Because I did the rollover immediately after receiving my paycheck, my Roth 401k contributions have not yet grown in value. That means I don’t need to pay taxes on my Roth 401k contribution earnings because I didn’t earn anything yet. Worst case, I might owe a few cents on the rollover when tax time comes around.
What’s The Catch?
As I went through the process of rolling over my money, Fidelity wanted to charge a $20 transaction fee. This means that it may be best to wait and do the Mega Backdoor Roth Conversion once a year. By rolling over your after tax 401k contributions into a Roth IRA, and your pre-tax earnings into a Traditional IRA, you can defer your taxes and minimize the transaction fees that your brokerage charges. Interested in opening a Roth IRA, join Betterment here and get your first $5000 managed for free. Want to choose your own investments and customize your portfolio, join M1 Finance and earn free money when you fund your Roth IRA or individual brokerage account within 30 days.
401k Contribution and Rollover Limits
As I mentioned the Roth IRA has a contribution limit of $6000 per year ($7000 if over age 50). As of 2021, the contribution limit for a 401k is $19,500 with a total contribution of $58,000 ($64,500 if over age 50). Assuming you are maxing out your 401k at $19,500, the mega backdoor Roth allows you to put up to $38,500 of after-tax dollars in a Roth IRA. Here is another example – If you (and your employer match) only contribute $10,000 to your 401k in 2021, then you can contribute and rollover up to $48,000 of after-tax dollars. That is much higher than the $6000 contribution limit of the Roth IRA. Think of the tax-free growth of a Roth IRA. Think of the compounding income. Think of the advantages of the Roth IRA in retirement – no requirement to take distributions, no problem passing the Roth IRA down to your children, etc. The Mega Backdoor Roth Conversion is an incredible tool to grow your money quickly, especially if you start young. Before you go and try the mega back door Roth conversion, consult with a financial planner or tax expert so you are not surprised with unexpected taxes. Subscribe Here to follow my personal finance hacks and 7 year mortgage pay off journey.
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