Mega backdoor Roth. Convert to Roth 401K or Roth IRA?

[jamesbond007]

My employer is offering mega backdoor Roth option. After tax contributions, in-service withdrawals. So, my question is do I convert my after-tax contributions to Roth 401K or Roth IRA? What are the pros and cons? Am I still allowed to perform my regular backdoor Roth IRA? This stuff is confusing.

[afuera]

Here is a thread from a little bit ago that might be helpful: https://forum.mrmoneymustache.com/welcome-to-the-forum/401k-after-tax-contributions-in-plan-roth-conversions-mega-backdoor/msg2777942/#msg2777942

and my response to that thread if you don't want to search too hard.  Mega Backdoor Roth (401K) doesn't impact Backdoor Roth in an IRA AFAIK.

I've been doing a Mega Backdoor Roth in my 401K for the last 3 years so I have some insights.
First, you need to see if your 401K plan offers in-service withdrawals/conversions.  This means that they allow you to convert the after-tax contributions that you make into either a separate bucket inside your 401K (Roth in Plan Conversion) or allow you to send the after-tax contributions to an Roth IRA.  My plan allows for both so I just convert the after-tax contributions to Roth they day they hit my 401K and all the money stays inside my 401K in separate buckets.
One pitfall to look out for is if there are any frequency restrictions on withdrawals or conversions.  You want to do the conversion as soon as the after-tax contributions hit your 401K so that you minimize any growth and taxes you have to pay on that growth.  My plan has no frequency restrictions so I do a conversion every paycheck.
As far as the Highly Compensate Employee (HCE) restriction, this just means the company will limit the % you can contribute to a 401K in order to avoid messy tax laws where they could end up paying fines if they don't handle it right.  I am an HCE so my company limits me to only be able to contribute 40% on my income to a 401K.  This allows me to contribute 16% as Pre-Tax in order to take full advantage of the 19.5K tax deductible limit and then I contribute 24% as after-tax which I convert to Roth as my Mega Backdoor Roth.  So far, due to the 40% HCE limit, I haven't hit the overall 401K limit (58K for 2021) which includes Pre-Tax, Roth, After-Tax and Employer contributions but every year I get a little closer!
Let me know if you have any other questions and good luck.  Mega Backdoor Roth is an amazing strategy to maximize the amount of tax free money available to you once you start drawdown so that you are able to optimize tax brackets once you quit working.

[seattlecyclone]

Pros of converting to Roth 401(k):
* The conversion may be easier to do and/or require less time out of the market, especially if your Roth IRA is with a different firm than the 401(k).
* You'll be able to remain invested in institutional-level index funds if your plan offers those.
* The plan administrator should be doing some basis tracking for you (but keep your own records anyway).
* You retain the option to roll those funds into another Roth 401(k) in the future. Roth IRA -> Roth 401(k) rollovers are not allowed.
* Perhaps more protection against creditors from the federal ERISA law than you would get in an IRA.

Cons:
* You're stuck with the investment options offered by your employer. Many 401(k)s have expensive funds.
* If you want to withdraw the principal during FIRE you'll probably want to roll it into a Roth IRA at that time anyway to avoid the pro-rata withdrawal treatment that applies to Roth 401(k)s. You skip a step by going straight to IRA now.

Neither of these options should impact your non-mega backdoor Roth.

[ixtap]

Pros of converting to Roth 401(k):
* The conversion may be easier to do and/or require less time out of the market, especially if your Roth IRA is with a different firm than the 401(k).
* You'll be able to remain invested in institutional-level index funds if your plan offers those.
* The plan administrator should be doing some basis tracking for you (but keep your own records anyway).
* You retain the option to roll those funds into another Roth 401(k) in the future. Roth IRA -> Roth 401(k) rollovers are not allowed.
* Perhaps more protection against creditors from the federal ERISA law than you would get in an IRA.

Cons:
* You're stuck with the investment options offered by your employer. Many 401(k)s have expensive funds.
* If you want to withdraw the principal during FIRE you'll probably want to roll it into a Roth IRA at that time anyway to avoid the pro-rata withdrawal treatment that applies to Roth 401(k)s. You skip a step by going straight to IRA now.

Neither of these options should impact your non-mega backdoor Roth.

Also, if the in plan roll over is automatic, you may completely avoid gains while keeping everything in the market. Conversely, if you plan to rollover to IRA, but are limited by fees or timing, you may experience growth that will be taxed at your regular income rate.

[jamesbond007]

Pros of converting to Roth 401(k):
* The conversion may be easier to do and/or require less time out of the market, especially if your Roth IRA is with a different firm than the 401(k).
* You'll be able to remain invested in institutional-level index funds if your plan offers those.
* The plan administrator should be doing some basis tracking for you (but keep your own records anyway).
* You retain the option to roll those funds into another Roth 401(k) in the future. Roth IRA -> Roth 401(k) rollovers are not allowed.
* Perhaps more protection against creditors from the federal ERISA law than you would get in an IRA.

Cons:
* You're stuck with the investment options offered by your employer. Many 401(k)s have expensive funds.
* If you want to withdraw the principal during FIRE you'll probably want to roll it into a Roth IRA at that time anyway to avoid the pro-rata withdrawal treatment that applies to Roth 401(k)s. You skip a step by going straight to IRA now.

Neither of these options should impact your non-mega backdoor Roth.

Also, if the in plan roll over is automatic, you may completely avoid gains while keeping everything in the market. Conversely, if you plan to rollover to IRA, but are limited by fees or timing, you may experience growth that will be taxed at your regular income rate.

I see. My employer plan offers automatic "same day conversions" to roth 401k. They are fidelity and I am currently investing my 401K in FXAIX. I plan to do the same for this roth conversion too.

It looks like it all comes down to simplicity and less fees. Do I owe any taxes when I convert from Roth 401K to Roth IRA in the future, ideally 5 years before my FIRE date so I can start withdrawing from it?

[seattlecyclone]

There's no tax on a rollover from a Roth 401(k) to a Roth IRA. You also don't need to do this rollover five years before you withdraw. You could roll the Roth 401(k) into your Roth IRA, withdraw the principal a week later, and no tax will be due. Note that for this purpose the "principal" consists of the original amounts of your mega backdoor conversions, and does not include any growth that happened after the Roth conversions. To withdraw that growth for free from your Roth IRA you'll need to be 59½ and also have had some money in some Roth IRA for at least five years. Make sure to open a Roth IRA and contribute at least $1 sometime before your 54½th birthday and you should be all set there.

[terran]

SeattleCyclone's list is great. The one advantage I'll add for Roth IRA is that you can actually split the rollover so principle goes to Roth IRA and gains between contribution and rollover go to traditional IRA thereby deferring taxes on the gains. This could block regular backdoor Roth contributions, so it only makes sense if you don't make them or the 401(k) will let you roll the traditional IRA back in.

Since your plan does automatic rollovers to Roth 401(k) that's absolutely the way I'd go since it simplifies your life and minimizes taxable gains by rolling over quickly.

You don't need to worry about rolling over from Roth 401(k) to Roth IRA 5 years before you retire. Once you roll over it's just like you had made the original transactions into a Roth IRA in the first place. The non-taxable portion of the rollovers can be withdrawn any time without tax or penalty. The taxable portion of the rollovers won't be taxable but it will have a 10% penalty if withdrawn before it's been 5 tax years and the taxable portion comes out before the non-taxable part. It shouldn't be a big deal since the taxable part will be small if the conversions are being made automatically. See this table to better understand the Roth withdrawal ordering rules and tax repercussions.

[terran]

...withdraw the principal a week later, and no tax will be due. Note that for this purpose the "principal" consists of the original amounts of your mega backdoor conversions...

I might be misunderstanding what you're saying here, but this doesn't sound quite right, depending on the timeline. There's no tax, but there is a penalty on the taxable portion of any conversion made within 5 tax years of the withdrawal and the taxable portion comes up before the non-taxable "principal" (see the table I linked above). Like I said in my previous post, this is likely to be minimal, especially with automatic conversions.

[jamesbond007]

Perfect. I have been performing backdoor roth for a few years anyway, so I already have money in my Roth IRA. I will continue to do so. I will have my employer sponsored mega backdoor roll into a roth 401K and will convert all that principal into roth ira when it is time for retirement. But I guess if my DD inherits this roth, she will have to pay taxes? That's only an issue if she inherits before i covert roth 401k -> roth IRA?

[seattlecyclone]

...withdraw the principal a week later, and no tax will be due. Note that for this purpose the "principal" consists of the original amounts of your mega backdoor conversions...

I might be misunderstanding what you're saying here, but this doesn't sound quite right, depending on the timeline. There's no tax, but there is a penalty on the taxable portion of any conversion made within 5 tax years of the withdrawal and the taxable portion comes up before the non-taxable "principal" (see the table I linked above). Like I said in my previous post, this is likely to be minimal, especially with automatic conversions.

Right, I was looking at it from the perspective of automatic conversions where there's no time for any pre-tax growth to happen before the conversion. If there is some of this pre-conversion growth you could be facing a bit of an early withdrawal tax if you withdraw the portion of the principal attributable to this taxable conversion. The timing of the transfer from Roth 401(k) to Roth IRA doesn't really have any bearing on this though.

Perfect. I have been performing backdoor roth for a few years anyway, so I already have money in my Roth IRA. I will continue to do so. I will have my employer sponsored mega backdoor roll into a roth 401K and will convert all that principal into roth ira when it is time for retirement. But I guess if my DD inherits this roth, she will have to pay taxes? That's only an issue if she inherits before i covert roth 401k -> roth IRA?

Qualified distributions from a Roth 401(k) ("designated Roth account") are tax-free. Distributions after your death are qualified if they are more than five tax years after you opened your Roth 401(k). If you rolled another Roth 401(k) into this one, the five-year clock starts with the first 401(k). If your DD inherits before this five-year clock has elapsed, I believe any distributions in those first five tax years would be taxed the same as if you had made an early distribution during your lifetime. See this IRS link for more info.

[jamesbond007]

All right. Called fidelity and setup to make a same day in-plan conversion from after tax to Roth 401K. Thanks all. $33,500 more into tax free growth. 10 more years is $335,000+

[ender]

fwiw my last employer had auto conversions and I think I had like $0.01 cents worth of taxable gains all year.

My current one does not, so I have to call the day after I'm paid which is going to result in a few hundred in gains I think throughout this year.

I've opted for inplan conversions as it's just easier in either case. Auto conversions obviously are much easier and even when calling to manually do this, it's faster for them to submit an inplan conversion than rollover.

[jamesbond007]

Yes. I agree. I had to call them to set it up. It is automatic once it is setup.

[ericrugiero]

I had to do the after tax to Roth 401K conversions because my employer doesn't allow in service withdraws.  There are minor differences between 401K and IRA but eventually, you will roll the Roth 401K to a Roth IRA anyway. So, you will end up in the same place regardless.  I would recommend whichever one gets you better investment options with lower fees.  If the 401K has good investment options and automatic rollover, that's probably the simplest way.  Mine ( with Fidelity) automatically rolls any after tax contributions to Roth 401K the same day eliminating any taxes on growth.  I had to call to have that set up but now it's taken care of with no effort on my part. 

[ender]

I had to do the after tax to Roth 401K conversions because my employer doesn't allow in service withdraws.  There are minor differences between 401K and IRA but eventually, you will roll the Roth 401K to a Roth IRA anyway. So, you will end up in the same place regardless.  I would recommend whichever one gets you better investment options with lower fees.  If the 401K has good investment options and automatic rollover, that's probably the simplest way.  Mine ( with Fidelity) automatically rolls any after tax contributions to Roth 401K the same day eliminating any taxes on growth.  I had to call to have that set up but now it's taken care of with no effort on my part.

Man, my old 401k let me do that.

Now, I have to call in every 2 weeks to do it. It's annoying and while I've asked our HR department to see if we can change this, I get to talk to the Fidelity workplace planning folks every two weeks and get their pitch hah.

[jamesbond007]

I had to do the after tax to Roth 401K conversions because my employer doesn't allow in service withdraws.  There are minor differences between 401K and IRA but eventually, you will roll the Roth 401K to a Roth IRA anyway. So, you will end up in the same place regardless.  I would recommend whichever one gets you better investment options with lower fees.  If the 401K has good investment options and automatic rollover, that's probably the simplest way.  Mine ( with Fidelity) automatically rolls any after tax contributions to Roth 401K the same day eliminating any taxes on growth.  I had to call to have that set up but now it's taken care of with no effort on my part. 

Same.