Author Topic: Does the mega-backdoor Roth make sense for me?  (Read 489 times)

JumpInTheFIRE

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Does the mega-backdoor Roth make sense for me?
« on: September 28, 2017, 01:03:33 PM »
My employer recently added the option to make after-tax contributions to my 401k which opens up the possibility of doing a mega-backdoor Roth (MBR) scheme for me.  However, I'm not sure if it would benefit me or not so I thought I would ask all the tax gurus here for their opinion.  Currently I make around 75k and my savings goal is 50k per year.  Currently this is divided like so:

18k: 401k pre-tax
5.5k: Roth IRA
26.5k: Taxable brokerage

My employer now allows a maximum of 10% of salary to be contributed to the 401k after-tax.  So if I was to contribute the maximum amount I could only do 7.5k per year.  So if I took advantage of this my savings would look like this:

18k: 401k pre-tax
7.5k 401k after-tax (to be converted to Roth 401k)
5.5k Roth IRA
19k: Taxable brokerage

Pros of doing the MBR:
Investment gains will never be taxed after conversion
After 5 years I can withdraw the contribution without having reached 59.5 (of course, if it went into my taxable brokerage I could withdraw at any time without restrictions)

Cons of doing the MBR:
Additional paperwork (it looks like I will have to mail a paper form each time I want to do a rollover)
Additional headaches at tax time, and I believe a more complicated return has a greater chance of being audited
Company doesn't appear to allow rollovers to Roth IRAs, only an in-plan rollover to a Roth 401k (still looking into this)
With only being able to contribute 10%, I still have to put a large amount into taxable brokerage and can't hit the 54k limit
After FIRE, I expect to have a low income and if capital gains taxes stay what they are now I probably would have a 0% rate. 

My "official" FIRE number is 1M, but I currently have low expenses and hate having a job so it's possible I might pull the trigger much earlier, possibly at 500k.  With a 20k-40k income in retirement, does it make sense to go through the headaches of setting up and maintaining the backdoor or should I just continue allocating the savings how I currently am?  Any and all opinions welcome!

alexpkeaton

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Re: Does the mega-backdoor Roth make sense for me?
« Reply #1 on: September 28, 2017, 07:03:30 PM »
I've not done a backdoor conversion, but I've rolled over 401ks multiple times as I've switched jobs. The paperwork is pretty simple. I also don't think it'll be as complicated at tax time as you think, and I'm skeptical it'll make you the target of an audit. And, even if it did, you've done nothing wrong so it should be no big deal. :)

MDM

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Re: Does the mega-backdoor Roth make sense for me?
« Reply #2 on: September 28, 2017, 08:29:30 PM »
I've not done a backdoor conversion, but I've rolled over 401ks multiple times as I've switched jobs. The paperwork is pretty simple. I also don't think it'll be as complicated at tax time as you think, and I'm skeptical it'll make you the target of an audit. And, even if it did, you've done nothing wrong so it should be no big deal. :)
+1 to all those opinions.

OP, unless your 401k options are terrible (e.g., high fees), getting long term money into a Roth instead of taxable seems a good idea.  E.g., even with tax law status quo, when you start receiving SS benefits Roth withdrawals don't affect SS taxability but LTCGs do.

DavidAnnArbor

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Re: Does the mega-backdoor Roth make sense for me?
« Reply #3 on: September 28, 2017, 09:13:52 PM »
Instead of doing a Roth IRA, you can do a traditional IRA and save more tax money - at least a thousands dollars in less taxes. Then I would also do the megabackdoor roth as well. Rolling over the non-deductible (after tax) contributions into the 401Roth is perfectly acceptable. Then when you leave said employment you can in turn roll that 401k Roth into a Roth IRA account.

seattlecyclone

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Re: Does the mega-backdoor Roth make sense for me?
« Reply #4 on: September 28, 2017, 09:33:00 PM »
After 5 years I can withdraw the contribution without having reached 59.5 (of course, if it went into my taxable brokerage I could withdraw at any time without restrictions)

You don't even need to wait five years, not really.

A brief summary of the Roth IRA distribution ordering:
1) Contributions directly from your checking account to the IRA come out first.
2) Conversions from traditional retirement accounts (such as backdoor contributions) come out next, oldest first. If you converted some pre-tax money and some after-tax money in the same year, the pre-tax part comes out first.
3) Earnings within the IRA come out last.

The 10% penalty for withdrawing conversions within five years only applies to the part that you paid tax on at the time of conversion. Remember that your principal was after-tax already. The only part that you pay tax on at conversion was any growth that happened between the time you contributed the money to your after-tax 401(k) and the time you converted it to Roth.

For example, if you contributed $10k to your after-tax 401(k) and it grew $100 larger by the time you got around to sending in the form to convert it to Roth, you could withdraw all $10,100 the next day and you would only owe a 10% early withdrawal tax on the first $100. Convert relatively soon after you contribute to the 401(k) and any taxable growth should be negligible, which should in turn mean that the penalty for withdrawing that money within five years will also be negligible. In this example we're talking about $10 of tax to withdraw $10,100. That's hardly worth worrying about.

Don't put in a mental block saying you "can't" withdraw this money when withdrawing it triggers a 0.1% tax (or whatever the real number is in your situation). Consider whether you could make good enough use of that money to make the tax worthwhile, whatever the tax rate.

Additional paperwork (it looks like I will have to mail a paper form each time I want to do a rollover)
Quote
Additional headaches at tax time, and I believe a more complicated return has a greater chance of being audited

The mega backdoor Roth doesn't make your tax return that much more complicated at contribution time. It's just one extra line filled in on your 1040, there aren't any extra forms to file. I've been doing it since 2014 and haven't been audited yet, despite having several things that add way more complication than the mega backdoor Roth.
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The Roth IRA was named after William Roth, who represented Delaware in the US senate from 1971-2001. "Roth" is a name, not an acronym. There's no need to capitalize the final three letters.

Paul der Krake

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Re: Does the mega-backdoor Roth make sense for me?
« Reply #5 on: September 28, 2017, 09:37:57 PM »
The mega backdoor Roth doesn't make your tax return that much more complicated at contribution time. It's just one extra line filled in on your 1040, there aren't any extra forms to file. I've been doing it since 2014 and haven't been audited yet, despite having several things that add way more complication than the mega backdoor Roth.
Wait, what line are you talking about? I don't remember doing anything special on my return when I did it.

DavidAnnArbor

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Re: Does the mega-backdoor Roth make sense for me?
« Reply #6 on: September 28, 2017, 09:53:10 PM »
Depending on the roll over from the after tax to the Roth, there might be a small taxable portion if the after tax had earnings. If so that has to get reported somewhere on the 1040.

Paul der Krake

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Re: Does the mega-backdoor Roth make sense for me?
« Reply #7 on: September 28, 2017, 10:02:57 PM »
Ha yes, you're right. Looking at the 1099-R from previous years, it appears I never had gains, so nothing to report.

DavidAnnArbor

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Re: Does the mega-backdoor Roth make sense for me?
« Reply #8 on: September 29, 2017, 02:05:57 AM »
If you can put the after tax contribution into some kind of non-growing short term bond fund or similar then it won't grow and there would be no earnings to report.

JumpInTheFIRE

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Re: Does the mega-backdoor Roth make sense for me?
« Reply #9 on: September 29, 2017, 07:25:49 AM »
Thanks everyone for all the replies!  From what everyone has said, I think I'm going to do the MBR up to the maximum level my company allows.  It's good to have diverse accounts since there's no guarantee capital gains rates (or 401k/IRA regulations) will stay where they are now so I might as well protect what I can.  My 401k plan has great options (Vanguard total stock, total bond and international are all available) so I'll probably just keep the Roth 401k until I leave/retire and roll the pre-tax and Roth amounts into IRAs. 

ZiziPB

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Re: Does the mega-backdoor Roth make sense for me?
« Reply #10 on: September 29, 2017, 07:39:37 AM »
Thanks everyone for all the replies!  From what everyone has said, I think I'm going to do the MBR up to the maximum level my company allows.  It's good to have diverse accounts since there's no guarantee capital gains rates (or 401k/IRA regulations) will stay where they are now so I might as well protect what I can.  My 401k plan has great options (Vanguard total stock, total bond and international are all available) so I'll probably just keep the Roth 401k until I leave/retire and roll the pre-tax and Roth amounts into IRAs.

There is also no guarantee that Roth accounts will not become subject to taxation at some point...



JumpInTheFIRE

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Re: Does the mega-backdoor Roth make sense for me?
« Reply #11 on: September 29, 2017, 09:14:22 AM »
Thanks everyone for all the replies!  From what everyone has said, I think I'm going to do the MBR up to the maximum level my company allows.  It's good to have diverse accounts since there's no guarantee capital gains rates (or 401k/IRA regulations) will stay where they are now so I might as well protect what I can.  My 401k plan has great options (Vanguard total stock, total bond and international are all available) so I'll probably just keep the Roth 401k until I leave/retire and roll the pre-tax and Roth amounts into IRAs.

There is also no guarantee that Roth accounts will not become subject to taxation at some point...

That's why I also mentioned 401k/IRA regulations, it's all about having money in diverse accounts in case the rules change for a specific type (i.e. 401k, IRA, brokerage) of account.  Of course I can't do much if capital gains taxes go up AND Roths start getting taxed AND pre-tax 401ks become a thing of the past (which is being discussed in the current tax "reform" proposal) but I might as well be as diverse as possible to help shield myself from changes. 

DavidAnnArbor

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Re: Does the mega-backdoor Roth make sense for me?
« Reply #12 on: September 29, 2017, 10:15:28 AM »
There's also creditor protection in a 401k Roth as part of the ERISA rules

seattlecyclone

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Re: Does the mega-backdoor Roth make sense for me?
« Reply #13 on: September 29, 2017, 11:39:16 AM »
The mega backdoor Roth doesn't make your tax return that much more complicated at contribution time. It's just one extra line filled in on your 1040, there aren't any extra forms to file. I've been doing it since 2014 and haven't been audited yet, despite having several things that add way more complication than the mega backdoor Roth.
Wait, what line are you talking about? I don't remember doing anything special on my return when I did it.

Line 16. You're supposed to put the full amount of the rollover on Line 16a and any taxable portion on Line 16b.
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The Roth IRA was named after William Roth, who represented Delaware in the US senate from 1971-2001. "Roth" is a name, not an acronym. There's no need to capitalize the final three letters.

DavidAnnArbor

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Re: Does the mega-backdoor Roth make sense for me?
« Reply #14 on: September 29, 2017, 06:42:45 PM »
https://www.thebalance.com/pensions-and-annuities-3193176

Line 16 of Form 1040
If you drew any income from pensions and/or annuities during the tax year, it goes on line 16 of Form 1040.

That's the easy part. 
Line 16 is broken down into two categories. The space next to 16a reports the gross amount of distributions you received from pensions and annuities. Line 16b reports the taxable portion of these distributions. For example, you may have received a distribution of $12,000 from your 401(k) plan, but only $10,000 of that amount was taxable. The $12,000 gross amount would therefore go on line 16a, and the $10,000 taxable amount goes on line 16b. Line 16b is the amount that contributes to your overall taxable income.
Retirement Funds That Are Reported on Line 16
Distributions from the following accounts are entered on this line of your tax return:
  • 401(k) plans
    403(b) plans
    Civil Service Retirement System (CSRS)
    Federal Employees' Retirement System (FERS)
    Foreign pension plans
    Governmental 457(b) plans
    Thrift Savings Plan