What’s The Difference Between A Backdoor Roth IRA And A Mega Backdoor Roth IRA?

Hi, Dr. Dali. I was wondering if you could clarify the mega backdoor Roth vs Roth conversions for me.

I think I'm missing the big picture.

On the difference between the two.

I actually think this is a place where there's a lot of people confused out there. There's a backdoor Roth ira, there's a mega backdoor Roth ira, there are Roth conversions. Help us here, Chad. Help us build a framework that will allow people to, to understand the differences between these things.

Yeah, I actually had to go through Steve's speak pipe a few times there just to make sure, like I was following everything he said. Because even the wording, when someone is saying, hey, these are my options, you want to make sure that you're hearing them properly. In short, one of those is a tax neutral event. One of them is a taxable event. Roth conversions are the taxable event, Right. And this is the confusing part, right, because backdoor Roth IRA is technically a Roth conversion, but you're doing it ideally with after tax dollars, which then makes it the basis over. So it's a tax neutral then. So with the Roth conversion inside. So I'm going with this first point. So the first point is the current 401 plan that allows for Roth conversions that is going to be fully taxable. So if you have $50,000 in your 401 and then you convert it over that 50,000 over to your Roth 401k, that's $50,000 of taxable income. That is maybe that, maybe that is a good plan. Ideally, you know, it's not perfect. There's a lot that comes into it. It depends. But we love Roth conversions. We love Roth conversions with all of our heart. And they can become one of your biggest tax savings. But usually that doesn't get exciting until you are just about retired or income. Stop. Right up until about those RMD years. There's a really beautiful time in there where you can really take advantage of Roth conversions. On the other side of it, the true mega backdoor Roth, which when I, when I saw this question, Jim come in, I got super excited. You probably do not remember this, but my first guest post to White Coat Investor 2017, the Mega BackDoor Roth IRA. So this is one of my favorite topics. I was excited to get this one. But on that actual conversion there inside of it, so we're doing the actual after tax 401k, that's where it's different. So when you have a plan that truly allows after tax contributions inside of your 401k, this is not a tax Deduction, Right. It's after tax dollars going in. And then they allow the feature to either convert it to a Roth 401k or ideally they'll let you actually transfer it out to a Roth ira. In this example, that conversion for the most part is tax neutral. And that's where there's a big difference. Because a Roth conversion, completely taxable. A true mega backdoor Roth IRA. If your 401k plan allows it, for the most part, we'll call it a tax neutral event. So while they can easily get confused, drastically different game plans and tax consequences that come with them.

Yeah, well said. I think what people don't get. Okay, a backdoor Roth IRA is something you do with your IRA. A mega backdoor Roth IRA is something you do with your 401K. Right. Terrible name. I didn't come up with that name by the way. It was there before I got to it. But basically it's something you do with your 401k. Even though it says IRA, it's a 401k thing. All right. So if you can keep that much straight, that will help you a great deal. A Roth conversion is just a movement from one account to another account. The destination account is always going to be a Roth account. The originating account kind of depends a little bit. Most of the time when it's an ira, it's going to be a traditional ira, a rollover ira, some sort of mostly pre tax IRA that can also have after tax money in it. Within a 401, you often have three sub accounts. My 401 here at the White Coat Investor has three sub accounts. It has a pre tax account, it has a Roth account and it has an after tax account. And so the Roth conversion there, when I'm doing a mega backdoor Roth, as I do every year in that 401k is I move money out of that after tax account into the Roth account. Cause remember, an after tax, it's great that when you take it out, you don't pay taxes on the original contribution, but you gotta pay taxes on all the earnings. If you get into a Roth account, then you don't pay taxes on the earnings either. So that's the real benefit there of doing that. So keeping all that straight I think is a little bit tricky. If you don't talk about this stuff and write about this stuff every day, I'm not surprised that people are getting confused about it. And the rules are different for mega to backdoor Roth IRAs and the contributions there and how it works as opposed to a regular backdoor Roth ira. It's hard to keep it all straight. So we try to have tutorials up that'll walk you through it every time you need to do it. And it helps if you're doing it in one fell swoop every year too. But I know that can be hard for people to make all the contributions at one time during the year. What else can we say about Mega Backdoor Ross Chad that hasn't been said?

Yeah, I think unique opportunity in there because Steve did note that there was a solo K. So keep an eye on your solo K platform too because there are some solo K platforms that are much more flexible than you know, we, we use Fidelity quite a bit. Fidelity's, you know, solo K model is a real cookie cutter model. So if you really want to customize it, you can. But you can even get into there where you're doing a mega backdoor Roth through your solo K. So there's a lot of unique things to do in there. You know, if you get cranking up if that 1099 income is really high and you are doing a mega backdoor Roth, like the full 69,000 for this year, if the 1099 income is really good, but you're. Because you're giving up when you don't. If you do all that is after tax rate. If you wanted pre tax contributions but we lost them, now we get Roth dollars. You know, if you can kind of layer in a cash balance plan that can get you some more tax dollars in depends on your situation too. Like you know, our docs in California, you know, we're trying to do as many pre tax things as we can. So that's one thing to keep an eye on. And I think 401ks are getting so much better whether it's just from the actual investment lineup or now a scene more and more after tax options. And with that we're seeing even auto auto Roth conversion features. So pretty much saying as soon as you put the money into the after tax, it'll convert it automatically. Which as Jim noted there, that's ideal because you want the growth to occur on the Roth side. You don't want to put it in the after tax and then it's growing and then you do the conversion because that growth is still taxable. We've seen this with some of the Kaiser groups where they're now putting in that automatic Roth conversion feature. So if the 1099 income is there, really keep an eye on customizing a really neat solo K for yourself. But if you do have the option through work see if they have that auto conversion feature because that can take one thing off your to do list and also probably give you a little bit extra tax arbitrage in there with the auto conversion.

Yeah, this is definitely a part that trips some people up because the cookie cutter off the shelf. Vanguard Fidelity Schwab Solo 401ks generally don't allow these. You have to get a customized one. And we've got a list of people under the retirement accounts tab at White Coat Investor that can help you do this. You it's not that expensive for a solo 401k. It might be a few hundred bucks to set it up and like one or two hundred bucks a year to maintain it. So it's well worth it if you want to do mega backdoor Roth contributions. But it's not, you know, it's not typically a feature from, you know, the typical places you would go to to open a solo 401k and not want to pay fees on it. It's going to cost you something to add this feature. And if you have employees and you're, you know, it's no longer a do it yourself 401k situation, it introduces some additional testing to your 401k. And so we not only have testing to make sure we're not discriminating against our lowest paid employees when it comes to, you know, the employer match stuff, we also have additional testing when it comes to the backdoor make it backdoor Roth IRA contributions that Katie and I are doing. We're the only ones at the company doing these, but there's an additional test that sometimes requires us to make additional contributions to our other employees. So it can get really complicated. I've even heard it argued that make a backdoor Roth even in a solo 401k is not a do it yourself project. I think if you're really into this stuff, you can still do it as a do it yourself project. But if this isn't your hobby, you probably need some professional help to do this.

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