You know, we are big fans of effective tax and retirement structures. That’s why the Fidelity Mega Backdoor Roth is one of our favorites.
These plans allow you to make after-tax contributions as well as pretax contributions. Current IRS rules on the plan and rollovers make the structures much more attractive to the average person.
This guide will discuss setting up a mega back door Roth at Fidelity. I will also provide some planning ideas for structuring these plans and combining them with cash balance plans. Let’s get started.
Table of Contents
What is a Fidelity Mega Backdoor Roth?
The retirement structure itself is a twist on a 401(k). It allows 401(k) participants to contribute both pretax and after-tax funds that bring the dollar amount to the total annual contribution limit for a given year. After-tax contributions qualify for tax-free distributions to an IRA, an end plan, or an in-service rollover.
|Maximum After-Tax Contributions||Challenging Pro-Rata Rules|
|Included in Many Standard 401(k)s||Multiple Accounts Required|
|Low Administration Fees||1099-R Required|
|Simple Administration||Form 5500-EZ Filing|
When the employee makes the after-tax contribution, these contributions can either be rolled out of the plan into a Roth account or converted directly to Roth assets as an in-plan rollover. Assuming the compliance requirements are met, the employee will receive tax-free contributions.
I know this may sound a bit confusing, but I will try to break it down and make it easy. Many employers offer matching contributions for 401(k) plans, which can boost your retirement savings. If your employer offers matching contributions for a Roth 401(k), this can be an even bigger advantage, as the matching contributions will also grow tax-free.
What is the IRS Position?
For many years there was debate about how to structure these plans and if they were even legal. In the past, the IRS took a basic stance but did not offer much guidance on implementation or how to structure the plans.
However, the IRS essentially signed off on the structure while leaving a few caveats. They thought about the design and pro rata rules for many years. The IRS subsequently issued guidance under IRS notice 2014-54.
The IRS basically reversed a prior position and now allows taxpayers to roll over their 401(k) funds and allocate pretax amounts to it, traditional IRA, and the after-tax contributions to a tax-free Roth conversion. You have to make sure you get the mechanics correctly.
What is the Mega Backdoor Roth IRA?
Do you already contribute to your 401K and IRA? If so, you may be encouraged to learn about the Mega Backdoor Roth IRA. This ‘supersized’ version of the IRA allows larger contributions than the standard Roth IRA. While it used to be a ‘secret’ for many years, it’s gaining popularity.
A Backdoor Roth IRA allows an option for investors who make too much money for a traditional Roth IRA ($137,000 for single filers and $203,000 for married filing joint filers). If this is you, the Backdoor Roth IRA allows you to roll money already invested in a traditional IRA into a Roth IRA.
But you lose the tax benefit of the Roth IRA. You’ll owe the tax money when you roll over pre-tax money now. You could face a hefty tax bill, but your earnings and withdrawals are tax-free.
A Mega Backdoor Roth IRA works with investors with money in a 401K rather than a traditional IRA. Rather than getting maxed out at the standard $20,500 limit, you can invest up to $37,000 per year in a mega version.
For the strategy to work, you must:
- Have a 401K at work
- Your 401K must allow ‘after-tax’ contributions in addition to your pre-tax contributions.
- You must be able to transfer the after-tax contributions from your 401K to your Roth IRA.
- Have more money to invest after you max out your 401K and Roth IRA contributions for the year
If your employer allows after-tax contributions to your 401K, you can contribute a total of $56,000 ($37,000 + $19,000). However, this includes any employer match. For example, if you maxed out your 401K and your employer matched your contributions at $5,000, you contributed $24,000. This leaves $32,000 of your after-tax dollars free for investment in the Mega Backdoor Roth IRA.
How to Set Up a Fidelity Mega Backdoor Roth
Here are the 5 steps to getting your Mega Backdoor Roth up and running:
- Determine if your current plan allows for Mega Backdoor option
Remember that most basic plan documents that come from investment custodians (and are free of charge) do not have a Mega Backdoor Roth option. For this reason, you’ll have to go to a custom document provider to have them establish the 401(k) plan. The plan document can then be taken to Fidelity to set up the corresponding investment accounts.
- Create or amend the plan document
Because a traditional Fidelity 401(k) plan does not come with the Mega Backdoor option, you’ll need to create a custom plan document. This document can amend and replace the existing Fidelity document. Alternatively, you can create an entirely new 401(k) plan and custodial accounts to fund the pretax and post-tax contributions.
- Set up the investment accounts
You want to reach out to Fidelity to ensure they set up the required investment accounts. There should be three accounts: (1) pre-tax contributions; (2) after-tax contributions; and (3) Roth contributions. While you can commingle the contributions in one account, it was highly recommended that you break the accounts out separately for tracking purposes. By contributing to both traditional and Roth 401(k) accounts, you can diversify your tax treatment in retirement. You can withdraw money from your traditional 401(k) in retirement and pay taxes at that time, while withdrawing money tax-free from your Roth 401(k) account.
- Determine investment options
Because Roth and after-tax money is tax-free, your most aggressive investments should be in this account. For any pretax deferral or profit-sharing, you should invest these amounts more conservatively. Remember that when reaching for large investment gains, you should use the Roth allocation. It would be best if you rolled your contributions over to a Roth IRA and the earnings to a traditional IRA so that you don’t lose the tax benefits of your after-tax contributions.
- Establish pretax and after-tax contributions.
Remember that the mega has three components: the deferral, profit, sharing, and after-tax contributions. You also can select the Roth 401(k) deferral option and make any after-tax contributions instead of profit sharing. Under this approach, the entire contribution would be after tax. Unlike a Roth IRA, which has income limits that may prevent some high earners from contributing, anyone can contribute to a Roth 401(k) plan, regardless of income.
A Roth 401(k) is a retirement savings plan that combines features of a traditional 401(k) plan and a Roth IRA. The main advantage of a Roth 401(k) is that contributions are made with after-tax dollars, meaning you don’t get a tax deduction in the year you contribute, but you can withdraw the money tax-free in retirement.
Use these simple steps to start your Mega Backdoor Roth IRA:
- Maximize your pre-tax 401K contributions
- Set up your paycheck to invest after-tax contributions on top of your pre-tax contributions. Roll over the after-tax contributions to a Roth IRA immediately (if your employer allows in-service rollovers)
- If your employer doesn’t allow a rollover to a Roth IRA, you’ll have to wait until you leave that job.
If you can’t roll your contributions to a Roth IRA right away, talk with your tax advisor about how to separate the contributions and earnings when transferring them.
If you already max out your employer-sponsored 401K and traditional IRA, look into the Mega Backdoor Roth IRA. You’ll invest after-tax dollars to a much more significant amount, and your contributions and earnings are tax-free. With a limit of up to $56,000, you stand to save a lot more money for retirement with tax benefits.
With a Roth 401(k), you can withdraw your contributions and earnings tax-free in retirement, as long as you meet the qualified distribution requirements. Roth 401(k) accounts are not subject to required minimum distributions (RMDs). This means you can leave the money in the account to continue growing tax-free.