Life isn’t fair. Some people want to do the mega backdoor Roth (see previous article The Elusive Mega Backdoor Roth), and they can afford it, but their 401k/403b plans don’t let them. Some people are in a plan that allows it but if they go full tilt their net paycheck will be too small for their current living expenses. What if you fall into this second scenario?
You can still take advantage of the mega backdoor Roth if you have money saved outside retirement accounts. If you were investing money in a regular taxable account before you discovered that you have the mega backdoor Roth available to you, you can effectively move some of that taxable money into a Roth account.
You set up the payroll deduction for non-Roth after-tax contributions to your 401k or 403b plan. If that drops your net paycheck next to nothing, you just sell some of your taxable investments to make your ends meet.
Even if you have to pay capital gains tax when you sell your taxable investments, it’s still worth it. I made a spreadsheet to show it. Here’s an example:
|Assets in taxable account now||$10,000|
|Capital gains tax rate now||20%|
|Marginal tax rate at time of 401k distribution||40%|
|Capital gains tax rate at retirement||20%|
|Tax rate on dividends||20%|
|Dividend distributions in taxable account||2%|
|Extra cost in 401k||1%|
|Number of yours in plan until rollover to Roth IRA||1|
|Number of years until withdrawal||30|
|End value in Roth IRA||$85,436|
|End value in taxable after paying capital gains taxes||$76,190|
I included 5% state income tax on dividends, capital gains and 401k distribution. If you sell the $10,000, after paying capitals gains tax you are left with $8,800. You spend this $8,800 while simultaneously contributing $8,800 as non-Roth after-tax to your 401k or 403b plan. After staying in the plan for 1 year, you roll it over to the Roth IRA, paying 40% taxes on the gains during that 1 year. Your Roth IRA will grow to $85,436 tax-free in another 29 years. If you don’t do the mega backdoor Roth, your $10k in taxable investments will grow into $76,190 in 30 years after all taxes are paid. You are better off by 12% with the mega backdoor Roth.
If you don’t have as much unrealized capital gains in your taxable investments, for instance if you have a cost basis of $8,000 instead of $4,000 in your $10,000 investments, doing the mega backdoor Roth would be 21% better.
As usual, you can enter your own assumptions and see how it comes out for your scenario. The online spreadsheet is here:
If you have the mega backdoor Roth available to you, don’t forego the opportunity until you exhaust substantially all your taxable investments.
For more on mega backdoor Roth, please read:
- The Elusive Mega Backdoor Roth
- Mega Backdoor Roth Without In-Service Distribution
- Mega Backdoor Roth and Access To Your Money Before 59-1/2
- Mega Backdoor Roth In Solo 401k: Control Your Own Destiny
[Photo credit: Flickr user yat fai ooi]