The Mega Backdoor Roth IRA and Other Ways to Maximize a 401(k)

Did you know: Numerous 401(k) retirement plans allow after-tax contributions. This creates financial planning opportunities that are frequently overlooked. Read this blog post for more information on maximizing your 401(k) plan.

The most popular workplace-sponsored retirement plan is far and away the 401(k) — a plan that can be both simple and complex at the same time. For some of your clients, it functions as a tax-deductible way to save for retirement. Others might see its intricacies as a way to maximize lifetime wealth, boost investments and minimize taxes. One such niche area of 401(k) planning is after-tax contributions, an often misunderstood and underutilized area of planning.

Before we jump into after-tax contributions, we need to cover the limits and the multiple ways your clients can invest money into 401(k) plans.

Employee Salary Deferrals and Roth

The most traditional way you can contribute money to a 401(k) is by tax-deductible salary deferrals. In 2019, employees can defer up to $19,000 a year. If they’re age 50 or older, they can contribute an additional $6,000 into the plan. In 2020, these numbers for “catch-up contributions” rise to $19,500 and $6,500 respectively.

Someone age 50 or over can put up to $25,000 into a 401(k) in 2019 and $26,000 in 2020 through tax-deductible salary deferrals. Additionally, the salary deferral limits could instead be used as a Roth contribution, but with the same limits. The biggest difference is that Roth contributions are after-tax. And as long as certain requirements are met, the distributions, including investment gains, come out income tax-free, whereas tax-deferred money is taxable upon distribution.

Employer Contributions

Employers often make contributions to a 401(k), with many matching contributions. For instance, if an employee contributes 6% of their salary (up to an annual indexed limit on salary of $280,000 in 2019 and $285,000 in 2020), the company might match 50%, 75%, or 100% of the amount. For example, if an employee earns $100,000 a year and puts in $6,000 and their employer matches 100%, they will also put in $6,000, and the employee will end up with $12,000 in their 401(k). Employers can also make non-elective and profit-sharing contributions.

Annual 401(k) Contribution Cap

Regardless of how money goes into the plan, any individual account has an annual cap that includes combined employee and employer contributions. For 2019, this limit is $56,000 (or $62,000 if the $6,000 catch-up contribution is used for those age 50 and over). For 2020, this limit rises to $57,000 ($63,500 if the $6,500 catch-up contribution is used for those age 50 and over).

Inability to Max Out Accounts

If you look at the limits and how people can contribute, you might quickly realize how hard it is to max out a 401(k). If a client takes the maximum salary deferral of $19,000 and an employer matches 100% (which is rare), your client would only contribute $38,000 into the 401(k) out of the maximum of $56,000. Their employer would need to contribute more money in order to max out.

Where After-Tax Contributions Fit In

Not all plans allow employees to make after-tax contributions. If the 401(k) did allow this type of contribution, someone could add more money to the plan in the previous example that otherwise maxed out at $38,000.

After-tax contributions don’t count against the salary deferral limit of $19,000, but they do count toward the annual cap of $56,000. After-tax contributions are what they sound like — it’s money that’s included into the taxable income after taxes are paid, so the money receives all the other benefits of the 401(k) like tax-deferred investment gains and creditor protections.

With after-tax contributions, clients can put their $19,000 salary deferral into the 401(k), get the $19,000 employer match, and then fill in the $18,000 gap to max out the account at $56,000.

Mega-Roth Opportunity

If the plan allows for in-service distributions of after-tax contributions and tracks after-tax contributions and investment gains in separate accounts from salary deferral and Roth money, there’s an opportunity to do annual planning for Roth IRAs.

Clients can convert after-tax contributions from a 401(k) plan into a Roth IRA, without having to pay additional taxes. If a plan allows in-service distributions of after-tax contributions, the money can be rolled over to a Roth IRA each year. However, it’s important to note that any investment gains on the after-tax amount would still be distributed pro rata and considered taxable. Earnings on after-tax money only receive tax-deferred treatment in a 401(k); they aren’t tax free.

Clients can roll over tens of thousands of dollars a year from a 401(k) to a Roth IRA if the plan is properly set up. They can even set up a plan in such a way so the entire $56,000 limit is after-tax money that’s distributed to a Roth IRA each year with minimal tax implications. This strategy is referred to as the Mega Backdoor Roth strategy.

Complexities Upon Distribution of After-Tax Contributions

What happens to after-tax contributions in a 401(k) upon distribution? This is a complex area where you can help clients understand the role of two factors:

  1. After-tax contributions are distributed pro-rata (proportional) between tax-deferred gain and the after-tax amounts.
  2. Pre-tax money is usually considered for rollover into a new 401(k) or IRA first, leaving the after-tax attributed second. The IRS provided guidance on allocation of after-tax amounts to rollovers in Notice 2014-54.

Best Practices for Rollovers

Help your clients navigate the world of rollovers with after-tax contributions by following best practices. If a client does a full distribution from a 401(k) at retirement or separation of service, they can roll the entire pre-tax amount to a new 401(k) or IRA and separate out the after-tax contributions to roll over into a Roth IRA. The IRS Notice 2014-54 previously mentioned also provides guidance for this scenario.

You can help your clients understand after-tax contributions by envisioning after-tax money in a 401(k) as the best of three worlds. These contributions enter after taxes and give your client tax-deferred money on investment growth, allow them to save more money in their 401(k) while also giving them the opportunity to roll it over into a Roth IRA at a later date.

After-tax contributions build numerous planning options and tax diversification into retirement plans. Before your clients allocate money toward after-tax contributions, it’s important they understand what their plan allows and how it fits into their overall retirement and financial planning picture.

SOURCE: Hopkins, J. (17 December 2019) "The Mega Backdoor Roth IRA and Other Ways to Maximize a 401(k)" (Web Blog Post). Retrieved from

7 more retirement and annuity facts you should know

Originally posted August 8, 2014 by Warren S. Hersch on

How many women and Gen-Xers have calculated how much money they will need to retire?  To what extent does working with a financial advisor increase individuals’ retirement confidence? What are the tax implications of boomers who are retiring later, saving more and planning better?

Answers to these questions, among many others, are forthcoming in the Insured Retirement Institute’s “IRI Fact Book 2014.” The 198-page report, an all-encompassing guide to information, trends and data in the retirement income space, explores the state of the industry, annuity product innovations, and solutions for generating immediate and future income needs.

The report also details consumer use and attitudes towards annuities, spotlights trends among baby boomers and generation X women, examines boomer expectations for retirement this year, and delves into the regulation and taxation of annuities.

Fact 1: Three-quarters (75 percent) of households that own fixed annuities claim balances of less than $100,000, while 68 percent of variable annuity owners report balances below $100,000.

For households with between $500,000 and $2 million in investable assets – the sweet spot for advisors serving the “mass affluent market,” more than a quarter have a fixed annuity balance of $1-$19,000 (28.1 percent) or $20,000-$49,000 ($24.4 percent)

Others with investable assets between $500,000 and $2 million have the following fixed annuity balances:

● $50,000-$99,999: 8.7 percent of owners

●$100,000-$299,999: 15.5 percent owners

● $300,000-$499,999 3.2 percent of owners

● $500,000-plus: 0 percent of owners

Fact 2: Nearly half of households (43 percent) cite guaranteed monthly income payments as the primary reason for purchasing an annuity.

This fact holds true, the report states, among investors with less than $2 million in investable assets. Investors owning investable assets between $2 million and $5 million place the greatest importance on potential account growth (41 percent). The wealthiest investors value insuring portions of their assets (39 percent).

Households with $2 million to 5 million in investable assets cite the following reasons for purchasing a variable annuity:

● 33.7 percent: To generate a guaranteed payment each month in retirement.

● 41.0 percent: To provide a potential for account growth.

● 35.5 percent: To receive tax-deferral on earnings in the annuity.

● 30.7 percent: To provide diversification by adding another type of investment to the portfolio.

● 32.2 percent: To protect assets by insuring a minimum value of payments from the account.

● 17.4 percent: To set aside assets for heirs.

● 16.7 percent: To exchange an old annuity for a new one.

● 5.6 percent: Not sure why I purchased an annuity.

Fact 3: The economy has had a detrimental effect on retirement savings and planning for many women.

The report indicates that few women are confident that they will have enough retirement savings or that they have done a good job preparing financially for retirement.

● 51 percent of Boomer women and 57 percent of Gen-X women have weak or no confidence that they will have enough money to live comfortably in retirement or are unsure.

● Significant numbers of both Gen-X and Boomer women (69 percent and 46 percent, respectively) have not attempted to calculate how much they will need to retire.

● Though expecting personal savings to be a significant source of retirement income, only half of Boomer women with savings have $200,000 or more in retirement savings. And only one-quarter of Gen-X women have $100,000 or more saved for retirement.

● Fewer than half have worked with a financial advisor to plan for their retirement. Those who do seek an advisor report that retirement planning is a top reason.

Fact 4: Working with a financial advisor greatly increases retirement confidence.

● Among those who consult with a financial advisor, 73 percent feel very or somewhat prepared for retirement compared with 43 percent of those who did not.

● Among Boomers who have calculated their retirement savings needs, 44 percent are extremely or very confident compared with 29 percent of those who did not. Among Gen-Xers who completed the calculation, 47 percent are extremely or very confident, compared with 28 percent among those who did not.

● Annuity owners have higher levels of retirement confidence. Among boomers who own an annuity, 53 percent are extremely confident, compared with 31 percent who do not. Among Gen-Xers who own an annuity, 49 percent are extremely or very confident, compared with 31 percent among those who do not.

● 7 in 10 Boomer and 6 in 10 Gen-Xer annuity owners have completed a retirement savings needs calculation. This compares with 44 percent of Boomers and 34 percent of Gen-Xers who do not own an annuity.

● Nearly three-quarters (74 percent) of Boomer and 62 percent of Gen-Xer annuity owners have consulted with a financial advisor. This compares with 35 percent of Boomers and 30 percent of Gen-Xers who do not own an annuity.

Fact 5: Boomers are showing some optimism that their financial situation will improve during the next five years.

The report reveals also that boomers are retiring later, saving more and planning better.

  • A quarter of Boomers postponed their plans to retire during the year past.

● 28 percent of Boomers plan to retire at age 70 or later.

● 80 percent of Boomers have retirement savings, with about half having saved $250,000 or more.

● 55 percent of Boomers have calculated a retirement savings goal, up from 50 percent in 2013.

Tax policy implications and positive actions

● Three in four Boomers say tax deferral is an important feature of a retirement investment.

● Nearly 40 percent of Boomers would be less likely to save for retirement if tax incentives for retirement savings, such as tax deferral, were reduced or eliminated.

● Boomers planning for retirement with the help of a financial advisor are more than twice as likely to be highly confident in their retirement plans compared to those planning for retirement on their own.

Fact 6: Most advisors (71 percent) have increased the net number of retirement income clients served during the year past.

The report shows that 60 percent of advisors have modestly increased their net number of retirement income clients, while 11 percent have significantly increased the number. An additional 28 percent and 2 percent, respectively, experienced no change or decreased their retirement income clientele.

The research adds nearly 6 in 10 (58 percent) advisors describe as well developed the processes and capabilities they’ve established for their retirement income clients. An additional 37 percent of advisors believe they have some but not all of the needed processes and capabilities.

Nine in ten advisors say that enhancing their retirement income processes and capabilities is a “priority.” For a majority, the priority level is high (54 percent). Fewer advisors describe the priority level as moderate (37 percent) or low.

Fact 7: Advisors generally rely on a combination of four major investment product categories for retirement income clients: mutual funds, ETFs, variable annuities and fixed income annuities.

For 1 in 3 advisors, all four categories are used in combination. About 2 in 9 advisors use mutual funds, ETFs and variable annuities. Other grouping include mutual funds and variable (1 in 8 advisors), income annuities (1 in 11 advisors), plus mutual funds and ETFs (1 in 12 advisors).

The following is a percentage-based breakdown of the most typical product combinations:

● 38 percent –Fund/ETF/FA/Fixed

● 22 percent –Fund/ETF/VA

● 8 percent—Fund/ETF

● 5 percent—Fund only

● 12 percent—Fund/VA

● 9 percent—Fund/VA/Fixed

Treasury issues final rules regarding longevity annuities

Originally posted July 1, 2014 by Daniel Williams on

Good news on the retirement front.

Today, the U.S. Department of the Treasury and the Internal Revenue Service issued final rules regarding longevity annuities.

According to the ruling, "these regulations make longevity annuities accessible to the 401(k) and IRA markets, expanding the availability of retirement income options as an increasing number of Americans reach retirement age."

In commenting on the ruling, J. Mark Iwry, a Senior Advisor to the Secretary of the Treasury and Deputy Assistant Secretary for Retirement and Health Policy, said:  “As boomers approach retirement and life expectancies increase, longevity income annuities can be an important option to help Americans plan for retirement and ensure they have a regular stream of income for as long as they live.”

Cathy Weatherford, president and CEO of IRI weighed in on the ruling: “The availability of longevity annuities in workplace plans and IRAs will facilitate access to a steady stream of guaranteed income throughout a retiree’s later years and help Americans enhance their retirement security at a time when they are most vulnerable to outliving their financial assets or facing reduced standards of living."