I've been blogging for doctors and other high-income professionals for 15 years now. Over that time, I have answered a half dozen or more questions every day from readers and listeners. If you do the math, that works out to 365 * 15 * 6 = 32,850 questions. Needless to say, most of them are repeats (and they have blog posts written that comprehensively answer them).

Very rarely these days do I get a question for the first time. Even more rarely do I get a question to which I don't know the answer. It's a “stump the chump” moment. Well, I got stumped recently. A WCI reader wondered if it might be advantageous not to make Mega Backdoor Roth IRA (MBDR) contributions IN ADDITION TO their regular Roth 401(k) contributions but INSTEAD of them. Here is the emailed question:

“My workplace 401(k) has the Mega Backdoor Roth option, which works via an immediate in-plan conversion where the money stays in the 401(k). I am currently only able to contribute $23,500 of the $70,000 limit, which I am doing as a direct employee Roth contribution. My question is, would contributing this money as if I was doing the Mega Backdoor Roth (via in-plan conversions of after-tax contributions) instead of as a direct employee contribution have any benefits?

My thought was that doing so may trigger the five-year Roth conversion clock, which would allow me to access that money in early retirement. However I have been unable to confirm that that is how it works. I am 28, so this seems like a good way to have money potentially accessible for early retirement while also getting the benefit of long-term tax-protected growth should I end up not wanting to retire early. The IRS website page “Retirement plans FAQs on designated Roth accounts” seems to indicate that in-plan conversions are not subject to the 10% early withdrawal penalty but are subject to recapture unless an exemption applies or the distribution is allocable to any nontaxable portion of the in-plan Roth rollover (I assume this is like a pro rata rule for a withdrawal of commingled after-tax and Roth money, but I am not really sure as I'm not aware of a scenario where a portion of the money converted to Roth would not be considered taxable income). My understanding of the webpage is that the five-year recapture for in-plan conversions essentially acts the same as the five-year conversion rule in IRAs, and that after the five-year period, the converted money within the 401(k) could be withdrawn without penalty despite being younger than age 59 1/2 at the time of withdrawal.

I have never heard anyone talk about doing this, and when I look into this further online, I only see discussion of Roth conversions in the context of IRAs. I am not sure if I am interpreting this incorrectly, or if the discussion is just typically centered around IRAs due to the assumption that the person converting is in (early or regular) retirement and not doing conversions as part of a 401(k) contribution strategy while they are still working. It seems to me that the tax due would be equivalent when doing the in-plan conversions instead of employee contributions due to the money being immediately converted. However from what I can tell, there doesn't really seem to be any benefit to doing that unless it gives the added flexibility of penalty-free access to the money for early retirement.

The only potential pitfall I see with this strategy is that my employer match is only based on Roth or traditional contribution percentage, so I would still need to contribute that percentage to the employee contribution to receive the match. This, however, can be done easily on my 401(k) provider's website at any time. I also only have one W-2 job, so freeing up employee contributions for use in multiple employer plans isn't necessary in my situation. Is there anything I am missing that may cause me to not want to do this?”

Well, I was glad he didn't leave this lengthy question on the WCI Podcast “Speakpipe” (it has a 90-second limit), and I was glad he gave me all the necessary details to answer the question. It was a “way out in the weeds” kind of question for sure, so don't feel bad if you don't know the answer either (much less if you don't care about the answer).

The Quick Answer

Initially, I misunderstood the question and discouraged him because what he wanted to do was so unusual:

“No, bad idea. Are you sure your MBDR has to take the place of your employee contribution? That's weird, and there's no point. The point of MBDR is to get MORE than $23,500 (2025, under 50 [visit our annual numbers page to get the most up-to-date figures]) in there. Here's more info on the five-year rule.”

In retrospect, that was the right answer, but it wasn't as complete as he really wanted it to be, so he clarified what he really wanted to know:

“The MBDR would not have to take the place of the employee contribution mechanistically; it is just that I am only able to afford doing $23,500 of total contributions. I think I made that unintentionally confusing, so I apologize. My thought was that I would contribute that amount via the MBDR instead of as a direct employee Roth contribution if that would give me the added benefit of the possibility to withdraw it before age 59 1/2. My understanding [is] Roth 401(k) contributions cannot be withdrawn at any time tax- and penalty-free like Roth IRA contributions can.

Essentially, I am unsure if the in-plan conversion from after-tax to Roth in a 401(k) is the same as the Backdoor Roth IRA exception listed under Five-Year Rule #1 of the post you linked, where there would be no early withdrawal penalty because the money was converted (after tax to Roth) instead of directly contributed (employee Roth contribution). My thought was that if this is the case, putting the money into my Roth 401(k) via the MBDR instead of direct contributions would provide extra withdrawal flexibility without a downside (as I won't be otherwise using my MBDR space to get additional money in, due to how much I can afford to contribute, and the money going into the 401(k) would still be Roth with the same amount of tax paid as if I did direct Roth contributions).”

OK, I understood what he was really asking. He was hoping that he could access Roth 401(k) money made via MBDR contributions earlier than via Roth contributions. The problem was that I didn't know the answer to that question, and I wasn't even sure where to find it. One nice thing about doing this for many years is you meet plenty of very smart people. As an emergency doc, I'm used to consulting others when I don't know the right answer. If the right answer in my clinical work matters tonight, I pick up the phone and “phone a friend.” If it doesn't matter tonight, I simply refer the patient to follow up with a specialist. It's no big deal to admit I need a little help, and in this case, I did.

So, I forwarded the question to two of my inspirations, the two bloggers who encouraged me to start WCI back in 2011 in the first place: Mike Piper at The Oblivious Investor and Harry Sit at The Finance Buff, both of whom have spoken at WCICON, have written all kinds of books, and have continued to blog about finances for decades. WCI Newsletter (free) subscribers know I refer readers to their articles frequently. As usual, I was impressed with their answers. We'll start with Mike, who gave the correct technical answer.

More information here:

Why MBDR Contributions Are Never Better Than Roth Contributions

First, let's make sure we're on the same page about a couple of points.

With a Roth IRA, you can always take money out; the question is simply what the tax treatment will be. With a 401(k) though—including a Roth 401(k)—we can't even take money out while still employed, unless various requirements are met (e.g., hardship distribution). If we're thinking: after-tax contribution > in-plan rollover to Roth portion of plan > take money out in some more advantageous way (while still employed), then no, I don't think that plan generally works.

If the plan is to eventually roll the money to a Roth IRA and then take the money out, now we're concerned with Roth IRA distribution rules rather than Roth 401(k). And in that case:

  • If the contribution had just been a regular Roth 401(k) contribution, it would now be treated as if it had been a Roth IRA contribution (able to come out penalty-free at any time), reported on Line 22 of Form 8606.
  • If the contribution was made after-tax, converted in-plan, then later rolled to a Roth IRA, it again counts as contribution basis (able to come out penalty-free at any time), again reported on Line 22 of Form 8606.
  • If the contribution was made after-tax and converted directly to a Roth IRA, then it counts as conversion basis (i.e., we have to wait five years), reported on Line 24 of Form 8606.

So, if the plan is to eventually move the money to a Roth IRA, going with the after-tax contribution is only going to provide the same outcome or worse relative to a regular Roth 401(k) contribution.

— Mike Piper

 

Like most of what is written by Jonathan Clements and Morgan Housel, I wish I'd written most of what Mike has, including this answer. It's clear, concise, accurate, and insightful. Surely, Harry Sit couldn't add anything to this answer, could he? Let's find out.

Make Fewer Things Matter

Before going into the weeds, I always ask, “Do I need a precise answer? What if it turns out I'm wrong?” Nine out of 10 times, I don't need a precise answer. If a precise answer makes a huge difference, I don't want to rely on it, because it's too fragile. I don't want to go down a path that only works when everything must be precisely correct. My guiding principle is to make fewer things matter.

In the case of a Roth IRA, committing to only withdrawing after age 59 1/2 makes it dead simple. There's only one test for tax-free distribution after age 59 1/2: having established the first Roth IRA at least five years ago. Saving one Roth IRA statement now easily satisfies that test. This avoids all the tracking, whether it's direct contributions to a Roth IRA, Roth 401(k) contributions rolled over into a Roth IRA, Backdoor Roth, Mega Backdoor Roth converted within the plan, or after-tax contributions rolled over from a plan into a Roth IRA. We want to maximize the tax-free growth in a Roth account anyway. So, don't even think about withdrawing before age 59 1/2.

Once you make that commitment, all the confusion goes away. You make it not matter how the money gets into the Roth account. Weeds are almost always a distraction. Go past weeds.

—Harry Sit

 

Harry was smart enough to realize this was a 28-year-old optimizer asking this question. The likelihood of the answer to this question ever really mattering to him rounds to zero. Instead of answering the question asked, he answered the question that should have been asked. Brilliant!

More information here:

The Bottom Line

The only point of a Mega Backdoor Roth IRA contribution is, as I stated originally, to put more money into the Roth 401(k) instead of investing it elsewhere. But a more important principle is to make fewer things matter—if not for you, then for your spouse and heirs.

It was no surprise then to hear how Mike responded to Harry's answer: “I like Harry's answer better.”

What do you think? Does your 401(k) allow MBDR contributions? Do you use them? Why or why not? 

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