Reach Financial Independence Faster: Backdoor & Mega Backdoor Roth Explained

17:04The problem with this complexity here is that the Roth conversion, as most people in the personal finance space that are reasonably adept will think of it, is really for the pre-tax, like the the traditional 401k conversion over to a Roth, which is another advanced strategy that is using the same terminology, but completely separate from what we're talking about with the backdoor Roth. And that's the thing that I think confuses people here. The backdoor Roth is literally using this worthless account, putting the limit into it, moving it over, and hopefully not having a gain that complicates your tax return inside of that.

17:38Amanda Han:You know, there's actually a name. So for what you're describing, the worthless account is called after-tax IRA. Right. It's only benefit is tax deferred growth. Right. For that short amount of time.

17:48Mindy Jensen:So just do it on Saturday when the markets are closed and nothing's growing.

17:52Amanda Han:I do think that really the most people who that fall victim to that worthless account is just lack of knowledge or, you know, they forget about it. Right. I did the first step. I didn't do the second step. That would kind of be the only reason why that would even come up. It's not even a big deal. Like you put it in there. It grows a little bit. You get a little tax. Move on. But it's just like, why not? Why? If you're going to do the Roth conversion point is move it quickly.

18:12Mindy Jensen:And is there any time that this doesn't make sense to do?

18:15Amanda Han:It's when you don't want money in a Roth or a retirement account at all, right? Maybe you need the cash to live off of or to buy your home or to invest in different assets or real estate that may not be ideal inside of a retirement account. One of the questions we get a lot right after we talk to clients about Roth, the follow up question most commonly heard is, great, when can I access that money? When can I pull it out? So for us, it's always really important to remind people that the purpose of having Roth money is not to pull it out. It is to leave it in there and let it grow exponentially for as long as possible on a tax-free basis.

18:50Amanda Han:So who is it not ideal for? It's not ideal for people who actually need the money right now.

18:55Mindy Jensen:Let's move on to the mega backdoor Roth. What is the difference between a mega backdoor Roth and a backdoor Roth? Main and huge difference between the mega backdoor and the regular backdoor Roth is that the backdoor Roth has to do with an individual retirement account. The mega backdoor Roth has to do with kind of that Roth bucket inside your qualified plan. So think of like a 401k at work where you've got a free tax bucket in there. Maybe there's an after-tax bucket. And then we've got this tax-free bucket, the Roth bucket. So I'm going to date myself 10, 15 years ago. These things didn't exist, right?

19:27It was just the 401k was a pre-tax account, but they've created these different buckets now that you can grow tax-free money inside a 401k. And there's basically something similar where you can kind of move that after-tax money you put into the 401k, into the tax-free bucket because different limitations and things. But it's pretty cool.

19:45Amanda Han:Yeah, the way it works, for example, in 2026, let's say you work at Google and you said, oh, I'm going to contribute$24 ,500 into my employee bucket. Maybe it'll be pre-tax. I'll get a tax deduction for it. On top of that, you can contribute after-tax money into your Google 401k. For example, I'll put another$32 ,500, right? It's an after-tax 401k. Similar to what we just said with the IRA, that 401k, you can convert that$32 ,500 into the Roth 401k. And that will now be, instead of going tax-deferred, it'll be growing tax-free. Same mechanism, just with certain employer accounts allow you to contribute more.

20:22What is the maximum I can contribute using a mega backdoor Roth? The maximum that can be done into the 401k is$72 ,000 this year. Now, that is combined between employee contributions and employer. So let's say your employer doesn't put anything in. You could put in up to$24 ,000 as$500 as employee pre-tax. And then the difference between$24 ,500 or$72 ,000 you could do as an after-tax contribution that you could then convert into the Roth bucket for the mega backdoor Roth.

20:50Mindy Jensen:Does the pro rata rule apply to a 401k or is that just for an IRA? That one's a good question.

20:57Amanda Han:I don't think I've ever heard of pro rata for 401k. I believe they look at the difference, right? So if you're, you know, look at your earnings, what you converted minus your basis is your earnings and you would pay tax on that. Let's say I get a$2 ,000 match from my employer and I put$20 ,000 into my IRA. I'm using this for easy numbers. And then I call up my HR department. I say, I want to do a$50 ,000 mega backdoor Roth. Is my HR department going to look at me like they know what I'm talking about? Or am I going to have to give them some help in order to help set this up? It depends, right?

21:27Amanda Han:I don't know who the HR is. They may know the answer, but a better person to ask is the plan administrator. So if your plan is with Schwab or T. Rowe Price, whoever it is, that would be the person to ask. And the question is, does the plan documents allow for that? Not all plans allow for mega, backdoor, all that kind of stuff. So just make sure you ask the question about whether that's allowed or not. That's a little bit more of a project here than the backdoor Roth, because you probably have to go through your plan administrator and or HR department in order to set up that up. Whereas the backdoor Roth, the mechanics of that can be done in an afternoon.

22:02Amanda Han:Yeah. Yeah. And I, you know, the reason I believe they call it a mega is because it's just a much larger dollar amount, right? Annually compared to the 7 ,000. So again, it's the mega backdoor is something that's allowed by the IRS, but you certainly have to check with your custodian HR employer to see if the plan documents allow it to do it at your work.

22:20Mindy Jensen:Okay. So because you have potentially pre-tax and post-tax money in your 401k, does the pro rata rule apply to your 401k as well for this mega backdoor Roth thing?

22:33Amanda Han:It does for one of the pro rata rules, because remember, we said there were two, right? The pro rata rule where, you know, I can convert my basis tax-free, not my earnings, that also applies to 401ks in the mega backdoor Roth arena. But the other pro rata rule where for the IRA concept where, you know, any pre-tax money then taints it, that does not apply in the 401k world. So you could have other pre-tax 401k. That doesn't mean your conversion is subject to pro rata allocation, only if there's earnings. So I think like in a typical scenario, somebody, maybe they have$10 ,000 of post-tax money, after-tax money in the 401k.

23:11They've got$15 ,000 of pre-tax money. So they got$25 ,000 in there. If they go and convert it, they're going to pay tax on whatever earnings they have in there. So the pro rata rule is definitely going to apply. it's just going to matter of how much you're converting and what's your ratio for sure.

23:26Mindy Jensen:Sounds like I need to talk to my CPA before I do any of this backdoor or mega backdoor Roth.

23:32Amanda Han:Yeah, I mean, I think I would go back to something that Scott said earlier, right? Which is, you know, why have money growing? So if I'm doing the mega backdoor in my 401k, I'm just going to contribute and convert in the same day or the next day to get rid of that issue. I would actually be quite surprised if many people have this problem, right? Because you have to be adept enough to set up a traditional account, which is neither a traditional 401k nor a Roth. And then also somehow create a situation where you did not immediately convert it within a reasonable period of time to have this problem.

24:08And if that's you, then it's time to call a CPA, I think, at that point to resolve this problem. But for everybody else, do not give yourself that problem. There's no reason to do that. You just like if you're going to use these accounts, convert it immediately and obviate this pro rata situation entirely. I think is that is that the right takeaway?

24:25Amanda Han:Yeah. The two step process. Just do it at the same time, guys. Even though I know we keep saying it's two steps, but just do it at the same time. I think it's worth mentioning. Right. Think about the power of that. Right. Because you gave that example earlier, Scott, right, where someone's put 20 grand in their employer put two grand in. Now, in a typical scenario, maybe that's all someone was typically doing to retirement. But if they've got a lot of excess money that they're not using or not earmarked for something else, they've got that$50 ,000. I think the power of being able to contribute an extra$50 ,000 essentially into a tax-free environment and let it grow tax-free for the rest of your life versus only putting$20 ,000 in, right?

25:01So, I mean, the compound of growth on that is going to be huge. So, this is where, you know, we know mechanic, we talk about the backdoor Roth. We talked about the mega backdoor Roth. And so now I want to put it together and say, what is the optimal order of operations for a high income earning household? That is primarily W-2 here. And so I want to spit this hypothesis out for your guys' feedback. So first, take your employer match. That's going to vary by your employer, but take it. That's the first step. The second is, and this is very heavily employer dependent, but take the employee stock purchase plan option, which can often be better than the next contributions to your retirement accounts, depending on the terms of that, especially if you can sell it immediately for a big game, like a 15 % discount.

25:43Number three is max your HSA. Do that before any of these mega backdoor Roth craziness if you're a high income earner. Number four is max out the 401k contribution or contributions,$24 ,500 each for each household member because we're a high income household. Next is ask your HR department if your employer allows after-tax contributions with in-service Roth conversions or ask them about the mega backdoor Roth. If they look at you with a funny face or refer you, then ask your IRA custodian for your company how to do that. For example, we had JustWorks or whatever it is, Fidelity at your company.

26:21Know that the max contribution is $72 ,000 less your employer match and your 401k max per person. After that, you can also do a regular backdoor Roth on top of that. So do that both spouses. And then from there, you can consider something like a 529 plan, but you've largely gone through the optimal stack at that point in that order. That's about$165 ,000 or a little bit more than that, actually, if you have gone through that entire stack for a married household. So that's an elite level of savings and will cover most even high income earning from a tax optimization standpoint. How do I do? Is that pretty close?

26:58Is that the way to implement this in order? Yeah.

27:01Amanda Han:I mean, I love the HSA towards the beginning, right? Because that's one of the few types of accounts where we get a tax deduction for the contribution going in. It grows tax-free and it comes out tax-free for medical. So definitely, a very superior investment product or tax optimization vehicle. The only thing I might tweak on that is I probably put the 7 ,500 Roth IRA before the after-tax 401k or the Roth 401k. And the reason for that is because for high-income earners who, depending on how much money they're making, what their goals are, I always want to put money into the backdoor Roth because I wasn't getting a deduction anyways.

27:39Amanda Han:It's going to grow tax-free. I'd rather have a grow tax-free than untaxable. But when we talk about retirement contributions into the work for O1K, you do want to take into consideration pre-tax versus post-tax retirement account. So that part, probably I would encourage people to put more thought into it when they meet with their CPA. Because Roth is great. Roth is great for tax-free money that's going forever, but just make sure you understand what you're giving up in terms of current deductions. I think you're right to correct me on that as well for another reason I didn't think of until you just said that, but the plan in a Roth, like let's say you go with Schwab or Fidelity with Roth that's directly controlled by you, those typically you can invest in ETFs with much lower fees than what your employer plan is going to offer, which often has very expensive fees there as well.

28:24So I think you're completely right. And I'm going to flip that order here. I think that's really good input. I mean, I think what you went through is worth its weight in gold. I think you should save that for the stage and maybe BP Con or something. that might be a suggestion. Charge money to listen to it. Yeah, I think that's for high income earners. It's not good for real estate. It's not good for maybe some other entrepreneurial stuff. There's different ones there. But I think this is how I would think about using these tools in the context of an elite income household. A couple of notes here as well is one, if you have a dependent care FSA through your employer, that belongs higher in the stack probably before you even max out the 401k, I would argue.

29:04And then if you cannot qualify for or cannot justify because of your health situation, an HSA compatible healthcare plan, then a healthcare FSA would swap for that. Do you guys agree with that as well? I think a lot of people know this, but those FSAs, you just got to be careful of the use or lose it features in there, right? Where you're not letting money just go to waste because I set aside as much as I could, but then I don't have the medical expenses I needed, right? So you just got to keep an eye on that. But yeah, I love those for sure. How do you think that going through a stack like this and using the backdoor Roth or mega backdoor Roth in particular changes the trajectory for financial independence?

29:42Amanda Han:I mean, it depends on the age of the client, right? Or person we're speaking with. I mean, if they're super young, it doesn't really help them reach financial independence any sooner because we just now have, we should say$150 ,000 tied up in account. That's going to be amazing once you reach retirement age and can access it, but it's not really going to help you replace your W-2 income anytime soon to stop working. If we're talking about someone who is older, closer to retirement age, then yeah, sure. I think those are maybe two different things, right? Financial independence to me is sort of like, how can I have more passive income, investment income today where I can utilize, which is different than just the theory and the talk around retirement accounts in general, which is saving for the future, right?

30:27Amanda Han:Benefits in the future. I think like from my angle, a different way to look at it, right, is I think it's you're setting up those habits, those good habits of putting those things in place. And because I'm going to date myself, but when the Roth IRA came out, I was a junior or senior in college and our tax professor, I mean, she was hammering it over our head every day about the Roth IRA. She's like, I can't believe they're doing this. Like you guys need to do this every single year. Don't be a moron. Don't be an idiot. Contribute to it while you can. And so I go back to that. It's just the habits of do this checklist of things every year and you're going to set yourself up for that future where you're going to have that financial independence at some point in the future.

31:02Amanda Han:I don't know if I noticed Matt said twice today already, like, I don't want to date myself.

31:07Mindy Jensen:I never want to date myself. It always happened when I was in college. Did you point in the 30s? I'm 25 years old, everybody. I'm 25. That's why you're maxing the Roth. So would my backdoor and mega backdoor Roth money that I'm putting in count as a contribution that I can then withdraw at any time? Because you can always withdraw the contributions at any time. With the backdoor Roth, with a Roth IRA, you are always allowed to pull money out. So your contributions to the Roth, you can also pull out money that you've paid taxes on. There's some there's some limitations. But generally speaking, you can always pull out your basis.

31:45And so that is a nice, flexible feature of a Roth IRA that if you do need money prior to retirement age for any reason, like an emergency or something, hey, I've got$20 ,000 of basis in my Roth IRA. I can pull that out and not have to worry about taxes or penalties. That is a pretty cool feature for sure.

32:02Mindy Jensen:So the$50 ,000 that I've put in through the mega backdoor Roth, that counts as basis. And I could just snatch that out. So if I'm making super high income throughout my, let's say, my 20s and 30s, and then I retire at 40, I can start pulling that out at around$50 ,000 a year because that's my basis, whatever my basis is. The hurdle with the employer plans, the 401ks, is that, again, we go back to that concept of the plan documents got to allow you to take these distributions out. So just because, again, the IRS says maybe you can do that, the plan document says, hey, if you're not 59 and a half, for example, you can only pull it out for A, B, or C reasons that you might run into some hurdle like that.

32:44Oh, okay.

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34:25You can get up to$3 million in coverage. Some policies are as low as$30 a month. That makes building a ladder genuinely fast. Get your free quote at ethos.com slash bpmoney. That's E-T-H-O-S dot com slash bpmoney. Application times may vary and rates may vary. One contradiction I want to talk about with this entire conversation, which I think is important because it's actually relevant to the entire strategy, is the person who's going to be using the backdoor or mega backdoor Roth is by definition a very high income earner, right? They're going to have income over the limits that allow for regular Roth IRA contributions.

35:02And in that situation, it is generally going to be best practice to defer taxes, right? That's going to be the bias we're going to come in that this, we're actually at a relatively high income earning year across our lifetime. And later in life and retirement, we're going to be in a lower tax income bracket. That's where that order of operations I just talked about is really important. We're going through the pre-tax or tax deferred stack first with the HSA and the traditional contributions and maxing those before we go through the Roth contributions in this particular case. Now, if we were much younger and lower income earning and expected our portfolio to grow massively, or we're very confident that we're going to become so rich that we're going to be in a high income tax bracket for the entirety of our life, then maybe that changes for the Roth contributions.

35:44But do you guys agree with that as a grounding mechanism? This is for a high saving, but also very high income earning household after they have gone through the pre-tax up. Certainly. Yeah. And, you know, obviously some of that requires a crystal ball that a lot of people don't have. But the funny thing is you'll ask people like, hey, you think you're going to be making more or less money in retirement age? And obviously most people are going to think they're going to say they're going to be making more money. Right. So you certainly have to take that in consideration in terms of, yeah, if you're at a high income, it's really hard to bypass that $24 ,500 pre-tax deduction you're going to get on your employee contributions, your 401k and say, Hey, I just want to do that into the Roth bucket and bypass my deduction.

36:22It's a hard pill to swallow, but certainly want to have that conversation with your team of advisors. Is there any argument to put the college savings before this in certain situations?

36:31Amanda Han:Like an ESA account? 529. 529 plan. I'm sure there's an argument somewhere. I kind of fall back to like, you know, know, we're talking about retirement for you, right? Like for you, the parent, and, you know, when you get to 70, 75, 80 years old, and you're going to need your money to live off of versus relying upon your kids' money at that point in time. So I kind of tend to fall like, let's take care of ourselves first. Maybe that's selfish, but... I mean, I will say 529 plans work really well. The younger your kids are, right? Because my kids, they're already going to go to college next year.

37:04Amanda Han:I'm getting one year of taxidermy growth. It also works really well for our clients who just have a lot of money in the brokerage account. You know, if I have a lot of money in my brokerage account growing in a taxable environment, then I would consider a 529 plan. So I'm still having money growing in brokerage, but now it's just growing tax-free because I'll be using it for college in, you know, five to seven years. Or maybe even like best of both worlds. Maybe you've got your money, you're doing that kind of the stack that you were talking about, Scott. but then you know grandparents have got some money on the side and they want to help their grandkids set aside money for college they can put their money into the 529 plan while you're putting your money into your own retirement i like that one that's a good situation right i work at google i make 500 600 000 i am able to go through my entire stack crush all that have a little bit left over to spend on a nice life and grandparents fun college education life life is good hey grandparents you don't need you don't need that money you don't need that money so i I love it.

37:59Probably not unrealistic in some scenarios for that. I think I'm talking on both sides of my bud. I don't know. That would be a great situation. So I guess if you can do it, then you also want to front load potentially the college savings and have that grow tax deferred in the 529 in there. But I think for most people, it's going to be the rare person who's able to go through that entire stack and make the max contributions to the 529 or even catch the five-year front loading or whatever. Life goals, right? So that's a good year. That's your SpaceX, you know, stock IPO sale year that you go through that whole stack.

38:32Mindy Jensen:Wait, say that again. What's that whole stack for that SpaceX listeners? The hypothesis, just for fun with our tax pros here. This will be timely because the SpaceX IPO is coming out soon. You take your employer match. You continue to take advantage of your employer stock purchase plan, which is exploding in value right now. If there's options in there, it depends on the circumstances. You max out your HSA. You max out your dependent care FSA if you have kids. You max out your 401k. You do your personal backdoor Roth. Then you do your mega backdoor Roth with your employer or your IRA custodian.

39:04Then you fully fund your kid's retirement accounts, which I think is up to five years of contributions you can front load. And that will likely defer state taxes depending on where you're at, but not federal. And then you have whatever is left over. That would be my stack for the SpaceX IPO employee. I don't know. That would be the first hypothesis. What do you guys think?

39:22Amanda Han:I love it. Except let's swap out the 529 contribution to be from grandma instead of us. Great. So we pay taxes, but buy half a Tesla with the same. Half of a Tesla. Yeah. The Californians are all selling their Teslas in the last few years. So I want to leave us with a parting thought here. I want to ask the audience. This was a backdoor and mega backdoor Roth discussion. Amanda and Matt, you guys added a ton of value here. Thank you for walking us through this. Another strategy I've been noodling on is if someone has a huge amount of money in their 401k, let's say they spent 20 years contributing to that.

39:59They haven't been able to go through this whole stack because they're not uber rich and making so much money they can go through it. So they've been prioritizing the 401k, taking the match, and they've got a million and a half or two million bucks in their late 40s or early 50s in there. And little wealth outside of that. Some, but not really meaningful amounts. Can you buy a nice rental property, accelerate depreciation, manufacture a major loss in the first year or two of early retirement, invest in certain types of assets that are very tax efficient for a rollover and convert that to a Roth in a big move?

40:30And is that a very powerful strategy for a lifetime employee? I want to ask if people are interested in that, if anybody knows anybody that's done that, and then if we want to have Matt and Amanda back on to talk about that. We would love to be back on to talk about that for sure.

40:43Amanda Han:I was like, we can't answer the question. That was a teaser. Oh, man. Let us know if that's an interesting one. And we'd love to hear a story of someone who has done that or has executed some version of that in the past as well.

40:54Mindy Jensen:Do you have to have real estate professional status in order to accomplish this, Scott? That's a question for Amanda and Matt. That's a question for when you come back.

41:01Amanda Han:Oh, yeah. We'll tell you in the next episode. And we do have clients who've done that, for sure.

41:07Mindy Jensen:Ooh, OK. We're going to have to talk about that because, yeah, Scott, feeling a little seen here with your comment about prioritizing the 401k for current year tax deductions instead of looking forward. And the reason you would do this is so you get money out of your 401k into the Roth account to let it continue to grow. But every dollar that you pull out of your traditional 401k and put into a Roth is no longer subject to RMDs when you turn 73 or whatever age you'll have to take RMDs at. I think this is a very first world problem impacting a good number of people who listen to personal finance podcasts instead of the chain smokers during their workouts and commutes.

41:47So I'd be interested to see if that's a shared view by the community. So Amanda and Matt, thank you so much for coming on and sharing your wisdom today. Where can people find out more about you? Yeah. Thanks for having us guys. It was super fun. Best place to find us is our website, keystonecpa.com. We have a lot of great resources and free information on there. Some of these topics, we actually have some stuff on there as well.

42:06Amanda Han:So yeah, best place to find me is probably Instagram and also YouTube as AmandaHanCPA.

42:13Mindy Jensen:All right, Amanda and Matt, thank you so much for your time today. I always learn a lot when I'm talking to you and now I gotta go talk to Carl about our backdoor and mega backdoor Roth scenario. So thank you so much for giving me some homework and for giving our listeners some homework. We will talk to you again soon. Awesome, thank you. All right, Scott, that was a whole lot of information that Matt and Amanda threw at us. I really enjoyed this show. I know I have a ton of homework to do. I am actually going to write an article for our newsletter and our blog detailing, based on what Amanda and Matt said, how to do the backdoor Roth and the mega backdoor Roth, because I think this is a really awesome strategy for people who are on their path to financial independence.

42:58Mindy Jensen:What did you think of the show? I thought it was great. I think that there's a lot of technical detail there. I think that the hardest thing about the backdoor and mega backdoor Roth is the complicated or technical sounding nature of it. And the very real idiocy, I'm going to use that word to describe the interim account that has no value and actually can be a complicating factor or pain in the rear if you leave any money in it, in this interim account. So it's the traditional account that's neither a pre-tax nor Roth that you have to contribute to then roll over into a Roth or use the parallel and the mega backdoor a Roth strategy.

43:32That's a very silly rule. It just it just is. And it allows any high income earner to get around these arbitrary limits to the Roth conversion. And I think that's the hardest thing, mental reframe to getting over this strategy and using the tool.

43:45Mindy Jensen:Yeah, I think if you're going to do this backdoor or mega backdoor participation, get in, do the contribution and then immediately convert to don't even wait a day because maybe the market has a great day. I mean, yeah, what a horrible problem. You have to pay taxes on$27, but don't complicate your life. Hit it, get it done, and then immediately convert. Like that should be the order of operations for that. Otherwise, you're going to be in a really long conversation with a CPA, you know, that's going to cost you hundreds of dollars in order to solve your pro rata$27 problem here. Like it's just like, this is a two-step process and it should be instant.

44:23Yeah, that's it.

44:24Mindy Jensen:Just put it in your mind. This is a two-step process that happens instantly. And my dear listeners, do you want even more financial independence information? Head over to biggerpocketsmoney.com and sign up for our newsletter. I send it out once a week with articles just like the one that's coming out next week, talking about the mega backdoor Roth and the backdoor Roth. We also have a ton of free resources, calculators, and templates to help you on your journey to financial independence. All right. Should we get out of here, Scott? Let's do it. That wraps up this amazing episode of the BiggerPocketsMoney podcast.

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