Many people may be missing out on a strategy out there: an after-tax 401(k) conversion to Roth. Roth accounts provide tax-free growth and tax-free access in the future (1). With that being said, many people are not utilizing their 401(k) to the best of their ability. This 401(k) conversion strategy, typically used by people with excess cash flow, allows you to contribute money into your tax-free bucket each year above IRS 401(k) employee deferral limits.
To utilize this strategy, your 401(k) plan must allow two things: after-tax contributions and in service withdrawals. Some plans allow this, and some don’t. I’ve met with a lot of people in the past that are missing out on this strategy. So, if you’re reading this, please check to see if you have this available by reaching out to your HR team. If your 401(k) plan doesn’t allow for after-tax contributions and in service withdrawals, then this strategy cannot be utilized.
Here’s how it works:
The total that can go into a 401(k) in the 2024 tax year is $69,000 if you’re under 50 years old (2). As an employee under 50, you can contribute up to $23,000 this year either on a pre-tax or Roth basis. Typically, your employer matches your contributions and possibly puts in a profit-sharing contribution as well. For easy numbers, let’s say the total employer contribution is $10,000.
This means that there is $36,000 of room left for the mega backdoor Roth strategy.
The math is as follows:
$69,000 (available contribution) - $23,000 (employee maximum contribution) - $10,000 (Employer match + profit sharing contribution) = $36,000 remaining.
Now, you can make after-tax contributions of up to $36,000 into the 401(k). Once these contributions are made, you can then convert them to either Roth 401(k) or a Roth IRA where they can grow tax-free. That’s the key here. The Roth conversions need to happen!!! If you don’t convert the after-tax contributions, the earnings on the contributions are taxed as income.
So, in this exact scenario, you could be putting an extra $36,000 into your tax-free bucket each year even after maxing out your 401(k)-employee deferral of $23,000. Doing this over the course of 10, 15, or 20 years can result in tax-free dollars that otherwise wouldn’t be available. That’s the power of the mega backdoor Roth 401(k) strategy and how it can be utilized.
This strategy is typically utilized by people with extra cash flow available. You need to evaluate your cash flow before deciding if this strategy can work for you and what amount (if any) may be good to contribute to the after-tax 401(k). In addition to working with a financial advisor, you should consult with a tax professional.
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