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Mega Roths Kick Retirement Savings into Higher Gear

The Mega Roth (aka Super Roth) 401(k) strategy continues to be widely misunderstood even though this “back door,” as it’s sometimes referred to, has been legal since 2014. Many retirement plans have not adopted the rules which would allow this complex strategy to be utilized. Most clients —and even some advisors — don’t even know that they are allowable.

To take advantage of this strategy, 401(k) participants should first max out their ordinary contributions (either pre-tax or Roth) to their plan. After that, they can make after-tax contributions to the plan that are then converted to either the Roth source within the 401(k) plan or a Roth IRA outside of the plan. (After-tax contributions to the plan are generally not matched by employers.)

As a result, 401(k) participants can potentially stash well above the ordinary annual limit of the Roth IRA.

It’s possible your clients have been asking about Mega or Super Roths, given all the mainstream press about how the Build Back Better Bill could eliminate this strategy. The bill didn’t muster enough votes in the Senate in late 2021 so it looks like the Mega/Super Roth 401(k) could still be available for a while.

That’s not to say that Build Back Better (now being reworked) won’t make a comeback. The Mega Roth could also be outlawed if similar language to what’s in the BBB is included in a different bill that has yet to be drafter or proposed. But for now, the strategy is worth exploring.

Who Benefits?

In my experience, the people who are most likely to use the Mega/Super Roth strategy fall into three categories:

  • Super Savers. These are the clients who have savings in their blood. They are always looking for ways to optimize their savings and the Mega/Super Roth is a great way to do it.
  • Empty Nesters. These parents have done their duty, sent the kids off to college and said children have successfully launched into adulthood. They are ready to kick their savings into higher gear and sprint to retirement.
  • High Income Earners. High earners often can’t save as much as they’d like in retirement plans because dollar contribution limits prevent them from putting in the maximum percentage. Executives, doctors, lawyers and other high earners can use the Super/Mega Roth strategy to shelter more so they can maintain the same standard of living in retirement as they enjoyed while working.

A Real-World Scenario

The Mega/Super Roth 401(k) can be an exciting way for people, even those with higher incomes who would otherwise not be permitted to contribute directly to a Roth IRA, to contribute to a Roth within their 401(k) plan. Let’s look at how this would work in a real-world scenario for 2022:

Bill, 58, and Linda, 60, are married and would like to retire in five years. They prioritized their children’s needs and saved heavily to support them through college. The children are all out of the house and are now starting their own budding careers. Bill and Linda are ready to play catch up with their own retirement and have dreams of traveling and perhaps even owning a little condo by the beach where they can winter in the sun. To do this, they have some aggressive savings goals to achieve, and they are ready to commit.

Their combined annual income is $300,000 ($150,000 each), which includes their base pay plus expected bonuses. Bill’s company allows pretax and Roth 401(k) contributions but does not allow after-tax contributions; therefore, he will not be allowed to do a Mega/Super Roth. Bill decides to max out his contribution to his 401(k) in pretax dollars. Linda has the option to do the Mega/Super Roth in her 401(k), but the plan will only allow her to do an “in plan” conversion. Here is what their savings could look like this year:

Bill’s pretax 401(k) contributions ($20,500 + $6,500 catch up) = $27,000.

Bill’s company will match 100% of Bill’s contributions up to 4% of his salary ($150,000 x  .04) = $6,000.

Linda is going to max out her pretax contributions just as Bill did at $27,000.

Linda’s company will match 100% of her contributions for the first 4% of her salary and 50% of the next 4% of her salary, meaning that they will match a total of 6% of her income = $9,000.

How much more can Linda contribute to the after-tax bucket and convert to the Roth 401(k) source, which will allow her to max out her contributions? Use this worksheet:

A. Total Contributions Allowed in 2022        $67,500 (she is age 50+)

B. Linda’s Pretax Contributions:                     $27,000

C. The Company Match:                                 $9,000

D. Take line A minus B minus C =                 $31,500

For a couple previously not allowed to contribute to a Roth IRA because their income exceeds the annual limit of $214,000, $31,500 is a huge sum to be able to put into a Roth for one tax year.

If Bill’s plan allowed the Mega/Super Roth, then he would be permitted to put an additional $34,500 into his plan ($67,500 – $27,000 – $6,000 = $34,500).

A few important notes about the Mega/Super Roth:

Catch-up Contributions

Participants age 50 or older by December 31 of the calendar year are allowed an additional catch-up contribution. Their total contribution allowable is greater due to the catch up ($67,000 instead of $61,000). See this flowchart for additional details.

Automatic In-Plan Conversions

Some 401(k)s allow automatic in-plan conversions. That means that as soon as money goes into the after-tax source, it is immediately converted to Roth. The benefit of having it automatically converted, if the plan allows, is that there is no growth of those after-tax funds prior to conversion.

If a 401(k) plan doesn’t allow after-tax contributions to be automatically converted to a Roth, the plan may allow one of two other things: 1) the participant may be able to pay taxes on the growth in the current calendar year and move it to the Roth source, or 2) the participant may be able to move the growth to the pretax source and move the after-tax growth to the Roth source, avoiding any additional taxation for the current calendar year. Doing more frequent, or better yet, automatic conversions of the after-tax money will minimize this issue.

A Rollover May Make Sense

Some people or advisors prefer the investing options of a Roth IRA brokerage account to the limited investments in the 401(k) plan. In that case, if the plan rules allow, they can convert and roll over the after-tax money instead of leaving it in the plan. Keep in mind any other legal or cost advantages of keeping money in the 401(k) such as federal protection from lawsuits or lower fee mutual funds that would not be available outside of the 401(k). (Some states protect IRAs from lawsuits, too.)

Separate Designations May Be Available

Some companies have a separate designation for withholding from regular paychecks vs. bonus checks. This can be nice if you are trying to manage a client’s cash flow. For example, if the client doesn’t normally use their bonus money for essential living expenses, they can do a larger contribution of the bonus account into the 401(k) so their goals are met without hampering their cash flow as much.

Help Clients Do Their Homework

Please refer to this list of important questions to ask your clients’ 401(k) providers to see if this strategy is an option for your clients or not. Most clients wouldn’t feel comfortable asking the provider all of these questions. You would do your client a great service to call the provider, with your client on the line, so that you can ask the questions and record the provider’s answers.

Since plans change their rules from year to year, it wouldn’t hurt to call periodically to see if there are any updates.

Beware of Maxing Out Too Early

You don’t want a client’s 401(k) contributions to max out too early in the year because they could miss out on matching contributions from the employer. Spread the contributions for the pretax or Roth contribution source (the portion that is matched by the employer) over the whole year to be safe. The only thing that will protect the client from this mistake is if the plan has a provision to “true up” the match that the employee would have received if they had contributed throughout the year.

Avoid Plan Penalties

Make sure that any conversions of after-tax funds to an outside Roth IRA will not trigger a penalty by the plan. Penalties usually preclude the client from being able to contribute to their plan for a specific period of time. So not only does the client miss out on their contribution, but they also miss out on matching contributions for that period of time.

Monica Dwyer, CFP, CDFA