In other articles I showed that contributing to after-tax 401k/403b and rolling it over to Roth IRA (the “mega backdoor Roth”) is great if your 401k/403b plan allows it. It’s still worth it even if you have to wait a few years before you can roll it over to Roth. You should still do it even if it drops your paycheck next to nothing. If you are self-employed, it may be worth paying a modest fee to enable this feature.
- The Elusive Mega Backdoor Roth
- Mega Backdoor Roth Without In-Service Distribution
- Mega Backdoor Roth Without a Big Paycheck
- Mega Backdoor Roth In Solo 401k: Control Your Own Destiny
A new question is, wouldn’t it lock your money up until you are 59-1/2?
What if you want to use your money before you are 59-1/2 because you will retire early or buy a house? If you just invest in a regular taxable account, you can tap your money anytime you want and you only pay capital gains tax. Do you lose flexibility if you push all your money into your Roth IRA?
Yes and no. It’s time to get familiar with Roth IRA’s ordering rules for distributions.
First of all, as you know, one great feature of Roth IRA is that you can withdraw your regular [direct] contributions at any time with no tax or penalty. Any money you withdraw from your Roth IRA is considered to come from your regular contributions first. If you need money before 59-1/2, you can always withdraw up to the sum of your regular contributions. However, if you haven’t been able to contribute directly to Roth IRA due to the income limit, this amount may not be much.
Second, everything is forgiven after 59-1/2 AND you have had any Roth IRA for 5 years. After that point it doesn’t matter how the money came into the Roth IRA; all withdrawals are tax free.
You are left to worry about withdrawing money above the sum of your regular [direct] contributions before age 59-1/2. The withdrawals go by this order:
- money you converted to Roth (including rollover from after-tax 401k/403b), first-in first out; and
- earnings on both your regular contributions and the converted money
If you wait 5 years before you withdraw your converted money, you are again forgiven. No tax, no penalty.
If must withdraw within 5 years (remember first-in first out), you look at how much of the conversion you paid tax on at that time. For example if you contributed $10,000 to your after-tax 401k and by the time you rolled it over to Roth it grew to $12,000, you paid tax on $2,000 when you rolled it over. Withdrawing this $12,000 within 5 years will have you pay a 10% penalty on the $2,000 but you don’t pay income tax on the $12,000. That comes out to paying $200 to withdraw $12,000, which is less than 2%.
If you had very little earnings when you rolled over, or if you did a split rollover (earnings went to a traditional IRA), withdrawing within 5 years will have you pay a 10% penalty on very little, or possibly zero.
Finally, earnings on both your regular contributions and the converted money are indeed locked up until 59-1/2, with some limited exceptions. After you exhaust all your converted money, withdrawing earnings before 59-1/2 will be taxable and subject to a 10% penalty.
Does doing the mega backdoor Roth lock up your money? For post-rollover earnings, absolutely. For your after-tax rollover itself, not much at all. If you stack up the rollovers and you always withdraw money from more than 5 years ago, there is no tax nor penalty. Even if you have to withdraw your after-tax rollovers within 5 years, you only pay 10% on the small amount of pre-rollover earnings. 10% on a small amount is very small. 10% of zero is still zero.
Bottom line, you still have good access to your money before age 59-1/2 when you do the mega backdoor Roth.
[Photo credit: Flickr user Len Matthews]
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