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Tuesday, March 22, 2016

My experience performing the "Mega Backdoor Roth Contribution"

I just initiated my first mega-backdoor Roth IRA rollover, and I figured I'd give a report out since it can be confusing. And even once you get the concept down, you have to figure out the actual *mechanism* in working with your institutions to actually make the rollover.

Background


[Note: this strategy is distinct from the normal "backdoor Roth". I provide a more detailed overview on why you might want to do this in my post My company offers an after-tax 401k. Should I contribute to it?]

If you aren't familiar with this process, the Mega Backdoor Roth takes advantage of the fact that individuals can contribute after-tax, non-Roth money to an employer retirement plan such as a 401(k) if your company allows it. This is over and above the normal $18,000 annual limit for Roth or pre-tax contributions. If your company allows in-service withdrawals of this money, (or you plan on leaving your company soon), you can roll this money into a Roth IRA effectively  bypassing the $5,500 annual limit on Roth IRA contributions. Normally leaving money in an after-tax non-Roth 401(k) is less favorable than simple taxable investment account investments (since you owe income tax on the earnings, not just cap gains tax), but viewed as a short term "pass-through" into a Roth IRA (where the earnings are tax free), an after-tax 401(k) can be a huge weapon in your FI arsenal.

Here's the Mad Fientist article on the trick, and I find it quite thorough.

Details


I have $6,142 of after-tax money in my 401(k). I only contributed $6,115 of this money, which means that $27 is "earnings" which have yet to be taxed. This is an important nuance: The contributions themselves have been taxed already, and can be rolled directly into my Roth IRA with no tax impact. The earnings however, if rolled over (and "converted" in the process) to my Roth IRA would be taxable income. No big deal, but since late 2014 the IRS allows you to actually split off these earnings and put those in a *traditional* IRA, deferring the income tax. This is what I wanted to do.

My 401(k) is with Fidelity, and my IRAs are with Vanguard. I first called Vanguard to initiate the process (as I know working with the receiving institution can be easier: they are the ones getting the assets, not losing them! They have an incentive to work with you). I'm not sure the Vanguard rep really understood the details of the tIRA/Roth IRA split, but I tried to move forward with them anyways. I wanted to do a direct transfer from Fidelity to Vanguard, and Vanguard said they needed to understand whether Fidelity required any paperwork. So I called up fidelity. The guy I spoke to seemed to be familiar with this procedure. According to him though, there was absolutely no way to do a direct transfer to an outside institution. After trying to sell me on opening an IRA *with Fidelity* (which isn't a bad idea, I just would rather stay with Vanguard for the time being), we initiated the transfer using physical checks.

Here's how it actually works: Fidelity will send me two checks in the mail, both made out to "Vanguard Fiduciary Trust Company for benefit of [my name]". One for $27 and one for $6115. I will then take these two checks and send them to Vanguard with a "letter of instruction" that I draft, instructing them to deposit the first check in my traditional IRA account, and the second in my Roth IRA account. Since the checks are made out to the other institution, not me, it's still treated as a trustee-to-trustee transfer, and they won't have to do the 20% income tax withholding on the $27.

Summary


All in all it seems straightforward. Although I would have liked to do a direct transfer without getting a check, it seems like the "split" of assets to Roth and tIRAs make this too complicated between institutions. It seems simple enough however, and after this is complete I will effectively have contributed $5,500 + $6,142 to my own IRAs this year. I'm only allowed to do this once a quarter per my retirement plan, so I'll finish hitting my $18,000 max in my pre-tax 401(k) by late summer, then dump even more money into the after-tax, non-Roth 401(k) in the fall, and go through this process again.

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