Is a Mega Back Door Roth Worth It?

With the turn of the year, everyone has all these resolutions and goals that they are trying to accomplish.  Some want to save more, some want to lose weight, some want to travel more, you get the idea.  The Mrs and I have our goals for the year and we’ve set some pretty ambitious savings goals, but one thing that I really want to get accomplished this year is to set up a Mega Back Door Roth.  So, I sat and thought about it, and I’ve done some research to fully understand it.  I even weaseled my way to over contributing after tax dollars to our solo 401k last year, even though Fidelity doesn’t technically allow it.  But, that was a hassle, and I don’t think it’s exactly what they had planned for their off the shelf solo 401k.  But I digress.  I’ve come to the point where I want to actually get this thing up and running and see what the actual benefits & costs are, and quite frankly, if is it even worth doing?

First things first, let’s start with what this is?  Why Mega or Back Door or even Roth for that matter?

Roth

If you have clicked on this link, and decided to read this far into this post, I’m gonna assume you know what a Roth IRA/401k does. (If you stumbled here, and don’t:  it’s like a brokerage account that eliminates capital gains taxes when you redeem everything after 65).

Back Door Roth

At the time of writing, the limits for contributing to a Roth IRA are: 132K single filer/194K married filer (2017 – 133K/196K, see here: Roth Limits).  So, if you make more than that, you are no longer eligible to take advantage of the lovely benefits of the Roth IRA.  So, what is a boy to do?  Well, there’s a law that allows you at any time to roll over your traditional IRA contributions to a Roth contribution.  If you have a large amount of money in your Traditional IRA you can run into some tax issues, but I’m not going to get into that here. (Ask in the comments, if you are curious) But for simplicity’s sake, we’re going to assume all your money is in a 401k or a Roth IRA, so you have $0 in a Traditional IRA.  Well, thanks to our roll over law, I can contribute the allowable amount ($5,500 at time of writing) to my Traditional IRA then roll that money directly over to a Roth the same day.  Vanguard makes this super nice and easy, you basically just click the roll over button.  They actually keep the money in a money market, so you end up with like $.07 in gains so there are no additional taxes on it.  You then invest it where you want.  It’s actually like one more step then just contributing directly to a Roth in the first place.  I actually started doing this long before we even approached the income limits because I’m weird (admittance is the first step in recovery. Signed yours truly, Mrs. WoW)  and I wanted to see how it worked.

Mega Back Door Roth

So the Back Door Roth is basically a shell game with Uncle Sam to get your money into a Roth IRA, not too horribly complicated, but a little more leg work.  So, what makes this one so Mega?  This is now a shell game that is played with in a 401k. Everyone knows that you can contribute $18k to your 401k that is tax advantaged, either PreTax or Roth.  Beyond that, your company can contribute up to 25% of the salary that you are paid.  But, the overall limit to a 401k annual contribution is $53K.  So if you contribute $18K and your company contributes another $5K or $23K total, you still have $30k left to hit your contribution limit, what about that?  Depending on the by laws in your 401k plan, you could potential make after tax contributions to your 401k so that they are treated as 401k contributions.  But, since these are after tax, you can roll these directly into your Roth IRA (again the timing of which depends on your plan by laws) and now you’ve just contributed $35.5K to your Roth for the year ($30K Mega + $5.5K Back Door).  Not bad right?  There’s a great post on some of the more intricate details over at Mad Fientist: Mega Back Door Roth.

Some More Background

There are a couple of blockers that make the MBDR rather tricky to get access to.  First, your 401k provider has to allow after tax non-Roth contributions, which is actually quite rare this day in age.  Ideally, they will allow you to make non-hardship in-service rollovers, meaning that you can transfer the money out of your account at any time, without penalties while the account is still active.  Again, this is pretty rare, I mean why would a fund manager want to allow you to transfer money out of your account that he collects 1% on?  I’ve looked into this at my place of work, and it’s just not going to happen, I’ve asked. A co-worker of mine even went as far as calling our provider and talking to their team, Nope.  Hell, I even tried it with our solo 401k and I had to do some fancy footwork to get it in, and now it’s in there, mixing with my pre-tax money, and I’m sure that’s gonna cause a headache shortly.

But, since the Mrs owns her own company, and I am the CFO, I can do what I want with our 401k.  I set up a solo 401k, simply because it was easier and we can contribute a larger amount on less gross income than a SEP IRA.  So we did that.  She contributes to her plan, her company matches 25%, all is good in the world.  Any additional funds, we’d just dump into a taxable account at Wealthfront.  But then I got to thinking, I have the ability to do what I want on this thing.  Why don’t I make it work to our advantage?  What does it take to make this happen?

I dug around online and came across a really great article on The Finance Buff about this exact topic: Mega Back Door Roth.  And this got me thinking, this isn’t all that hard to do, but is it worth it?  I requested some information from one of the service providers mentioned in the article, and my analysis ensued.

Is it worth it?

Well, at first glance, of course it’s worth it.  I mean, why would you not want to cram $30K or more into your Roth account each year?  But let’s look at it a little closer.  Here’s my line of thinking:

  • There are set-up, maintenance and documentation fees that will need to be accounted for with this new plan.
  • There is going to be a whole lot more management, organization and coordination on my side.  (The Mrs will tell you that organization is NOT my best quality)
  • If we keep our income down, especially after FIRE we could potentially get away without paying capital gains taxes on our assets.
  • We would have instant access to the money in a taxable account, not simply the principle like we would in a Roth, and after 5 years at that.

Let’s look at the Pros and Cons:

Pros:

  • We can put a ton more into our Roth accounts each year.  She can put around $30K, and for me I can put $53K (Crazy I know, but I have two active 401k accounts and you can contribute $53K to each one, although you can only contribute $18K tax advantaged personal contributions, which I use to reduce my income at work and maximize my employer contribution).
  • We can avoid capital gains taxes on the growth and a pretty substantial sum of money simply because it’s now in a retirement account.

Cons:

  • The set up fee is $775, the annual maintenance fee is somewhere between $100 – $300 a year depending on what I need.
  • There’s a lot of paper and leg work that goes into setting up all this stuff.  I’ll have to provide my own 1099-R’s, 5500ez or pay someone to do so.  That will be a new experience.
  • We will only have access to the principle and that’s after 5 years invested.

What really caused me pause on just pulling the trigger from the get go, is that you can have an AGI of up to $75,900 (as of writing) and pay 0% in capital gains.  Oh, and since we use Wealthfront, we’re stockpiling harvested tax losses to offset even more gains.  If that’s the case, where’s the advantage?  Why even go through the hassle?  The only income we’ll have, at least after we FIRE, would be converting our traditional IRA to our Roth on some set schedule, everything else would be draw-downs on our investments, and this is something that we have 100% control over.  I was actually starting to think it might not be worth the hassle, I mean if we can get the same benefits without the admin costs and the headaches of filing paperwork with the government, great.  I mean I hate dealing with the IRS.

The Golden State

But, then I had the wherewithal to take a look at California capital gains tax rates.   California has the 2nd highest capital gains taxes in the world.  Wow, so the Feds will allow you to have an income of $75K and pay $0, but CA would take your standard income tax % of those gains. So, unless we move, we’re gonna be stuck with that.  I was gonna do all this math and fancy analysis, but I think that just made my decision pretty easy.

I guess this means I’ll have to do more follow-up posts about how this whole process works.  Sounds like I’m gonna have a “Set up a Mega Back Door Roth Series”. Any takers??  I’ll try to keep it as detailed as possible, so if anyone wants to follow along, you can understand the whole thing.  If we move, I’ll just reassess our situation then, and hopefully we move to FL or TX where the capital gains would be $0, no matter what the feds do.

10 Comments

  • Julie @ Millennial Boss January 23, 2017 at 7:41 pm

    Luckily my company allows the after-tax 401k contributions and I can do an in-service withdrawal over the phone! I was wondering if it was really worth it long-term though. I’m in California but don’t plan to stay here forever. Thanks for the tip on the solo 401(k). I’m thinking of opening one up this year!

    Reply
    • Mr WoW January 23, 2017 at 8:00 pm

      You are very lucky from what I can tell. Everything I’ve looked into says that it’s exceedingly rare to find those this day in age.

      California is great and all, but wow do they have a vacuum on your wallet. I don’t know that we are going to be here forever either. That’s why I’m really wavering on whether or not to do this. The set up and maintenance costs are actually pretty large. So, the break even point is larger than you might think if we can make it happen in our standard taxable accounts with no capital gains, that would be way better.

      As far as a solo 401k, I went with Fidelity, opposed to Vanguard where we have everything else, simply because Fidelity lets you invest in the Spartan shares in the solo 401k, Vanguard only let’s you invest in investor shares, not the super cheap Admiral shares. The one pain is that Fidelity doesn’t do online deposits for the solo 401k’s yet, but I’ve been on the phone with them a bunch and hopefully that’s coming soon.

      Reply
  • Carolyn February 10, 2017 at 9:29 am

    >> We will only have access to the principle and that’s after 5 years invested.

    I thought that for the principal, you can withdraw it (from the IRA) at any point because it was contributed after-tax. I know if you did trad -> Roth IRA conversion, that has the 5 year waiting period, but I’m fairly certain the after-tax / Mega Backdoor doesn’t have the waiting period. That was one of the reasons that I went with the Mega Backdoor route rather than a regular brokerage account.

    Reply
    • Mr WoW February 10, 2017 at 10:37 am

      It looks like you might be right. But it’s limited to 5 years past the plan initiation date.

      See: http://www.rothira.com/roth-ira-withdrawal-rules

      And: http://www.schwab.com/public/schwab/investing/retirement_and_planning/understanding_iras/roth_ira/withdrawal_rules

      So, if I’m reading this correctly you don’t even have to wait the 5 years for a rollover, since that would be considered a contribution.

      Thanks for the heads up… I’ll make the change.

      And in our case, it still might not make sense since we’re managing the plan ourselves so we incur the costs. If yours allows it it might be worth while depending on the situation. It really comes down to if you think you’ll hit the capital gains limits, or live in California I guess.

      Reply
      • Carolyn February 10, 2017 at 12:32 pm

        I’m in Washington state, so no income tax 🙂

        I understand the drawbacks in your case. It’s interesting seeing the difference from the employee/employer sides.

        Reply
        • Mr WoW February 10, 2017 at 1:20 pm

          Must be nice:) But yeah, at this point I am thinking it might not be worth the effort especially since we’re talking about moving out of state.

          If I had the option without all the maintenence I would already be doing it.

          Reply
  • Phil February 10, 2017 at 10:51 am

    you pay taxes on your dividends on a taxable account while you don’t in an IRA. While I am sure the tax burden is low post-FI it would be substantial pre-FI depending on the funds you choose.

    Also if you have kids going to college, retirement account are not accounted into your expected family contribution while taxable assets are.

    Those are two pros that I thought of off the top of my head.

    Reply
    • Mr WoW February 10, 2017 at 1:24 pm

      Valid points. We use tax loss harvesting to offset the taxes on dividends at the moment. And as for the college funding. That might be something to consider in the future. We are running a 529 at the moment so hopefully that will subsidize it some.

      Reply
  • Stuart @ Epic Quiver April 21, 2017 at 9:20 am

    I’m not sure if after-tax contributions are as rare as folks think. My last three companies all allowed for pre-tax, ROTH and after-tax contributions to a 401(k) in any mix that you would like. I’m not sure if it’s because all of my companies have been Fortune 500 and have a wider employee base than most or what. My current company allows for in-service roll overs, not sure about the others, I never knew to ask about them at my previous jobs, but it is now one of the questions I plan to ask when considering offers for new jobs.

    Reply
    • Mr WoW April 21, 2017 at 9:37 am

      I’ve never been at a place that allows it. But then again, most of mine have been smaller companies. I do think when we have employees, I will make sure to write those possibilities into the by-laws.

      Reply

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