Mega backdoor Roth is catching on! Several readers emailed me saying their employer added non-Roth after-tax contributions and allowed converting to Roth within the plan (officially known as an In-plan Roth Rollover).
I didn’t ask but I don’t suppose they all work for the same employer. Some plan providers or consultants must be going to employers and persuading them to add these valuable features to their plans. At least one employer was specifically pointing out to the employees the advantage of making non-Roth after-tax contributions followed by converting to Roth within the plan.
Even though they may not advertise it, some employers also allow rolling over the non-Roth after-tax contributions and earnings to a Roth IRA. Be sure to ask your plan administrator about it. When you have both options available — converting the after-tax account to Roth within the plan or sending it to a Roth IRA — which one should you choose?
Only From After-Tax Sub-Account
Before you consider either option, you should make sure you are able to choose to rollover or convert within the plan only from the after-tax sub-account (your non-Roth after-tax contributions and the earnings on those contributions). If the plan mandates that you must pro-rate between your after-tax sub-account and money from your other pre-tax sub-accounts in the plan, then you shouldn’t do it.
The rest of this article assumes that you can choose to do it only from the after-tax sub-account. You must make that choice loud and clear to the plan administrator whether you are converting within the plan or rolling over to a Roth IRA.
Either option is a good one. Between the two, in general I would favor taking it out to your own Roth IRA, for some minor reasons which may or may not make much difference to you.
You have more investment options in your own Roth IRA. The investment options in your plan may be more expensive. However, some plans have great investment options. Some investment options in the plan such as a great stable value fund or institutional funds are better than the ones you can get on your own outside the plan.
If you take the money out of the plan to your Roth IRA, you can withdraw before you are 59-1/2. You may have to pay some tax on the withdrawal but at least you have that option. See Mega Backdoor Roth and Access To Your Money Before 59-1/2.
If you convert within the plan, the money is locked up until you reach 59-1/2, terminate employment, die, or become disabled. Of course if you leave your employer and you rollover the Roth 401k to a Roth IRA, you are able to withdraw before 59-1/2 again.
If you don’t care about withdrawing while you are employed and before you are 59-1/2, then this doesn’t really matter.
When you take the non-Roth after-tax money out of the plan, the IRS allows you to take the after-tax contributions to a Roth IRA and take the earnings to a traditional IRA. Some plans take advantage of this IRS rule and let you to do the split. This way you are not taxed on the earnings at the time of the rollover.
When you convert to Roth within the plan, there is no such option. You will always be taxed on the earnings when you convert.
While I prefer keeping it simple and just rolling over both after-tax contributions and earnings to a Roth IRA, and as a result paying tax on the earnings, you have the option to do a split when you take the money out of the plan.
If you rollover once a year, the earnings won’t be much. Sending the earnings to a traditional IRA will interfere with your regular backdoor Roth. If you care about the regular backdoor Roth, you will have to roll the earnings in the traditional IRA back into the plan. I think it’s too much trouble for too little gain. However, if you run into a great year when your after-tax contributions generate a lot of earnings before you do the rollover, it may be worth it to jump through the hoops with a split. It’s your choice whether you invoke the split option or not.
If you don’t mind paying taxes on the earnings when you convert, again this doesn’t really matter.
If you have a lot of earnings when you roll over the after-tax account to a Roth IRA and the value subsequently drops a lot, you have the option to recharacterize and pull the money out into a traditional IRA. After a mandatory waiting period, if the value doesn’t recover, you then re-convert the traditional IRA to a Roth IRA. This way you will lower the taxes you have to pay on your original rollover.
That’s a lot of if’s but it’s an option. If you convert the after-tax account to Roth within the plan, you don’t have this do-over option.
If you don’t have a lot of earnings to begin with, or if you choose the split rollover when you do have a lot of earnings, then this doesn’t matter.
As you see, other than the investment options, the reasons that favor taking the money out to a Roth IRA as opposed to converting to Roth within the plan are mostly just-in-case. Either way works. If converting within the plan is more convenient or if it’s the only option available in your plan, by all means do it. Just make sure you convert only from the after-tax sub-account, not from your pre-tax sub-accounts.
If you rollover to your Roth IRA, be sure to keep a journal of the transactions. See Maintain A Roth IRA Contributions and Withdrawals Spreadsheet.