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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Jeff says
TFB, Great article – but don’t forget that the IRS allows for penalty free withdrawals from Qualified Plans (Not IRA) at age 55 or 50 in certain scenarios. Another reason why diversification in assets types is huge when facing distribution needs.
“The following additional exceptions apply only to distributions from a qualified retirement plan other than an IRA:
Distributions made to you after you separated from service with your employer if the separation occurred in or after the year you reached age 55, or distributions made from a qualified governmental defined benefit plan if you were a qualified public safety employee (State or local government) who separated from service on or after you reached age 50.”
http://www.irs.gov/taxtopics/tc558.html
ameridan says
Don’t forget that you can invoke the 72(t) provisions once you start tapping into the earnings portion of your Roth IRA, assuming there are enough to provide income for 5 years or more. You won’t be subject to the 10% penalty if you receive a series of substantially equal periodic payments, or “SOSEPP,” from your IRA for the greater of five years or until you reach 59-1/2. If you have traditional IRA accounts, you might be better off tapping into those with SOSEPP instead.
OnlyKetchup says
Thanks for the great article. I’m going to be trying this next year and was glad to learn how accessing the funds early would work.
$iddhartha says
My employer allows me to put 10% of salary into “normal” 401k and 8% into after-tax. Thinking that there was little benefit to after-tax contributions, I had been putting money towards my own student loans instead.
Here’s a college savings scenario I haven’t heard discussed as it relates to this topic. I have two kids under age 2, and this seems like the ideal tool to save for their college expenses. I live in a state that does not allow pretax contributions to a 529 plan. Combine that with the fact that colleges don’t look at parents’ retirement accounts for financial aid purposes, and there is little incentive for me at all to use a dedicated 529 plan.
Great series of articles TFB. The mega backdoor Roth will without a doubt benefit my long-term goals. I just wish the rules weren’t so convoluted that only certain people can take advantage of them.
Harry Sit says
One advantage of a 529 is that you can use earnings tax free for college expenses whereas you can only withdraw the “principal” from the Roth IRA. I would still prioritize this mega backdoor Roth over a 529 plan.
Rod says
TFB I have a question for your consideration if you please.
Assuming that my 401k investment options are as good or better than what I would have on a Roth IRA, and I don’t need to tap into the after-tax contribution in the foreseeable future, do you see an advantage of still doing After-tax -> Roth IRA, instead of After-tax -> Roth 401k?
I read that (in California) 401k funds have better legal protection vs IRAs, I can also perform a Roth 401k -> Roth IRA rollover when I leave my company (or reach 59 1/2) without any penalty so I can “resume the Roth IRA avenue”. Last but not least, because I already have a Roth IRA open, when/if I rollover the Roth 401k I would not lose the 5-years log from the 401k Roth.
Thank you
Harry Sit says
Rod – It those assumptions hold true and your 401k plan can isolate the source when you do an in-plan rollover, making it after-tax -> Roth 401k, I don’t see a problem.
Rod says
TFB thank you.
Yes the plan is setup in a way that it can clearly identify 3 different “source groups”, one of them being after-tax. It is not setup to allow me for different fund allocation between 401k and Roth 401k but that’s a lesser problem since I’m applying a common allocation % to both accounts.
Caleb says
Hi Harry,
Thanks for the article. I’ve been looking into Mega-Backdoor for my upcoming bonus. It seems that according to the letter of the law, withdrawing an after-tax 401(k) backdoor conversion to Roth should incur no tax liability (assuming no gains on what was rolled over). Let’s go back to your 10k to 12k example. Let’s say instead of withdrawing $12,000, I withdraw $10,000. Do I incur a penalty of (10/12) * $10,000? Or is the $10,000 withdraw safe from any penalty?
Does the IRS require you to somehow specify if you are only withdrawing previous contributions or if the earnings are being withdrawn? Are there any tax-filing implications of making a contribution only withdraw from a Roth?
When I looked at trying to withdraw contributions from my Roth IRA from Vanguard they said the transaction would be reported to the IRS. Any idea what that means for me?
Thanks for any answers you can give.
Harry Sit says
Within that $12k, the $2k in pre-conversion earnings comes out first. If you withdraw only $10k you still pay penalty on $2k. This is different from withdrawing direct contributions.
Evan says
Hi Harry, I was a little confused by this at first, but I think I get it now. The trick is to separate pre-conversion earnings from post-conversion earnings, right? Your comment made this distinction, but the post did not.
When withdrawing money that comes from a “conversion” bucket, the pre-conversion earnings are withdrawn prior to the contribution for that conversion, but all conversion funds are withdrawn prior to any post-conversion earnings. Is that right? Here’s a scenario.
Year 1: Contribute $5k directly to Roth IRA.
Year 2: Contribute $4k to trad IRA, prior to conversion this grows by $1k, convert $5k to Roth IRA and pay taxes on the $1k pre-conversion earnings.
Year 3: Contribute $3k to trad IRA, prior to conversion this grows by $2k, convert $5k to Roth IRA and pay taxes on the $2k pre-conversion earnings.
Year 4: On top of the pre-conversion earnings, the total account balance has grown 20%, so you now have $18k and you want to withdraw money. The order of withdrawn money is as follows:
(assume withdrawals are prior to age 59.5)
First $5k – Direct contributions, no tax or penalty.
Next $1k – Pre-conversion earnings from year 1 conversion, not taxable but pay 10% penalty.
Next $4k – Indirect contribution from year 1, no tax or penalty.
Next $2k – Pre-conversion earnings from year 2, not taxable but pay 10% penalty.
Next $3k – Indirect contribution from year 2, no tax or penalty.
Remaining $3k – Post-conversion/-contribution earnings, taxable AND pay 10% penalty.
Is that right?? I think this is what Stephen was trying to ask when he said do “earnings come between yearly contributions”.
Harry Sit says
Evan – There is no trick, as in you don’t have a choice in the order of withdrawals. The order is mandated by law. As a result you must track the pre-conversion earnings and post-conversion earnings separately if there is any chance you will withdraw before 59-1/2. See Maintain A Roth IRA Contributions and Withdrawals Spreadsheet.
Your example is correct, assuming (a) all contributions to Traditional IRA were non-deductible; and (b) implicitly the withdrawal is done within 5 years of the conversions. If your Year 4 is Year 14 it will be different. The tax on the withdrawal can be reduced by limiting the withdrawal to $15k, leaving the post-conversion earnings untouched. Also, the numbers used for pre-conversion earnings are quite high (25% and 66% earnings within 1 year). If you use more reasonable numbers, you will see the penalty is quite low when you stop at the post-conversion earnings. The calculation method is correct though.
Evan says
Thanks Harry. By trick I just mean “trick to understand the rules”. And we are operating under the same assumptions 👍 I agree that the pre-conversion earnings might be high (esp 66%) but just wanted to pick easy but different numbers in case the amounts were going to be pro-rated (not the case).
Stephen says
Are these rules the same for the Roth 401K? Or to access the Roth 401K while still working, I would have to roll over the contribution amount I wanted to access to a Roth IRA, then access from there? Also for the Roth IRA, do you have to have separate accounts for each year? As you say it is FIFO, meaning any earning must come between yearly contributions so to access the second contribution you would have to go through the earnings as well? Or is it all contributions first then earnings?
In https://thefinancebuff.com/roth-ira-contributions-withdrawals-spreadsheet.html, it seems to say all contributions first correct?
Harry Sit says
Rules are not the same for Roth 401k. No withdrawals or rollovers from Roth 401k are allowed before 59-1/2 when you are still working for that employer. After you terminate, rules become similar.
For Roth IRA, FIFO only applies to conversions. Direct contributions come out first.
Jon says
That does not seem to be true in all cases. My company offers in-service rollover of Roth 401k funds that are the result of converting After Tax 401k to Roth.
In that case, if I convert from After Tax to Roth immediately (zero to little gains), then roll it into my Roth IRA after there are $2k in gains, do I pay a penalty on the $2k still?
Dave Anderson says
Great article. I’m a retirement plan advisor – mostly larger plans. I recently had a smaller employer/client approach me about this. This is a safe harbor 401k plan with a Roth feature. My understanding is that after tax contributions count toward ACP testing – even in a safe harbor plan. My fear is this is a relatively complex concept to communicate – one that may be utilized primarily by highly compensated employees and, in turn, likely cause the Plan to fail testing.
Your thoughts would be appreciated!
Harry Sit says
That’s correct. It may not work for a smaller employer. You can do a mock testing with some assumptions and see how the plan can pass.
Sean J. says
I would like to make after-tax contributions to my 401K plan and roll it over to a Roth IRA, so that my investments never incur capital gains tax again (aka Mega Backdoor Roth IRA).
Say I was able to successfully rollover $50K after-tax contributions (all principal, no earnings) from my Fidelity 401K plan to a newly-created Fidelity Roth IRA over 2 years. Also say hypothetically in Year 3, I decide to buy a fancy car and would like to use that $50K rollover after-tax contributions to do so. Will withdrawing the $50K in my Roth IRA trigger any penalty?
And what if I also previously had a separately active Vanguard Roth IRA from 10 years ago, will that change anything?
I have searched endlessly and I am reading conflicting opinions. From your article, it appears that withdrawing after-tax contributions rolled over into a Roth IRA will not incur a 10% penalty even when withdrawing within 5 years. I’ve also read elsewhere that the 5 year rule takes into consideration all your Roth IRAs, so your oldest Roth IRA actually dictates the start of the 5 year rule (this may be a moot point, if after-tax contributions are not subject to any penalty anyway). Another article said each conversion/rollover triggers the start of a new 5 year cycle. Again, there are too many conflicting opinions and would like to get clear answers. Please advise.
Harry Sit says
I didn’t say withdrawing within 5 years will not incur a 10% penalty. I only said the penalty may be very small. See example for withdrawing a $12,000 rollover in the post.
(1) All your Roth IRAs at different financial institutions are treated as one for withdrawals. You probably also read that withdrawing [direct] Roth IRA contributions is tax free and penalty free. Therefore if you have a Vanguard Roth IRA to which you made direct contributions, even when you leave that one alone and you withdraw from the Fidelity Roth IRA that received only rollovers from the 401k, it’s still treated as withdrawing your direct Roth IRA contributions first until you exhaust the sum total of your direct Roth IRA contributions.
(2) Each rollover does trigger a new 5-year cycle for that rollover. The 10% penalty applies within the 5-year cycle to the pre-rollover earnings. In your example, that would be to the growth on your $50k before it was rolled over, not to the $50k itself. If you didn’t have pre-rollover earnings, 10% of zero is zero. If your $50k only grew to $51k before you rolled it over, the 10% penalty applies to $1k, which comes out to $100 when you withdraw the $51k within 5 years. If you waited until your $50k grew to $90k before you rolled it over, the penalty would be larger.
Scott says
Hello–
What I’m reading in this article directly contradicts what Schwab retirement services just told me.
Scenario:
$10,000 contributed to a roth 401k then immediately rolled over to a roth IRA.
IRA has been open longer than 5 years.
Can the principal be withdrawn tax and penalty free (roth IRA rules)? They are telling me I need to wait until 59 1/2 since it is not a direct contribution to the roth IRA or I will be tagged with a 10% penalty…
Thank you,
Scott
Harry Sit says
You scenario is not valid. It also doesn’t relate to what you are reading here. A direct contribution to Roth 401k is not allowed to be distributed before 59-1/2 while you are still working at the employer. While it may be possible to take a hardship withdrawal, a hardship withdrawal can’t be rolled over to a Roth IRA.
https://www.irs.gov/retirement-plans/retirement-plans-faqs-on-designated-roth-accounts#Distributions
Scott Plooster says
Harry–
Thank you for your input. I am self employed (solo 401k) so I can close the plan at any time and roll the money into an IRA. I didn’t say that earlier because it seems to add another layer of complexity.
Thank you,
Scott
Harry Sit says
When you take a non-qualified distribution from a Roth 401k outright, the tax and the 10% penalty only apply to the earnings, not to the $10,000 itself. Rolling it over to a Roth IRA doesn’t make you worse off. Tax and penalty there still won’t apply to the $10,000 itself.
https://www.irs.gov/retirement-plans/designated-roth-accounts-distributions
Scott says
Harry– I wish I could buy you a beer. Thanks so much for the link and the clarification!
It is amazing that many tax professionals don’t even understand these nuanced rules.
Thank you,
Scott
Harry Sit says
I converted my tip jar to fundraising for The Salvation Army. You can be the first one to use it:
https://thefinancebuff.com/tip-jar
Sam says
Harry,
Thanks for the awesome article and write up. This is a great source of information. I am planning to start doing the Mega Back Door Roth and my employer and fidelity allows an automatic roth in-plan conversion. I don’t have any plans to quit in the next 10 years. I would like to access my contribution amount, prior to 59 1/2 years. I have a rather long & maybe basic question in this scenario
1) I have never had a Roth IRA and would likely open a new one. Say I deposit 31k each year, in equal monthly chunks, in after tax contribution. Since Fidelity can do an automatic conversion, this will immediately rollover from my 401(k) into a Roth 401(k), with little to no earnings. I would like to then rollover this Roth 401(k) to a Roth IRA. Should I do it immediately after each month’s automatic roth in-plan conversion or at the end of the year? Does the 5 year counter get reset each time I perform a rollover to my Roth IRA.
I went through the IRS FAQs and I think my scenario is similar to the Bob’s in the example below, but am not sure.
https://www.irs.gov/retirement-plans/retirement-plans-faqs-on-designated-roth-accounts#3rollovers
Thank you in advance!
-Sam
Jess says
Hi Harry, I contributed to After-Tax 401k and am enrolled in the Fidelity Roth In-Plan conversion. Can I assume or say the fund now sits under “Roth 401k” account (as opposed to “After-Tax 401k” bucket)? Let’s say there’s $1,000 contribution + $200 earnings in that bucket: after I rollover both amounts into Roth IRA, I can withdraw up to $1,000 penalty-free immediately (before age 59.5) without waiting 5 years, is that correct? (My first direct contribution to Roth IRA was over 5 years ago at Vanguard, thus the account is older than 5 years.) Thank you for your insight.
Harry Sit says
That’s correct. Tracking the split between your contributions and earnings (the $1,000 and $200 in your example) may be a challenge. Keep all your statements and record them in a ledger.
Jess says
Thank you so much for clarifying the above, Harry! Much appreciated! 🙂
Jess says
Hi Harry, I appreciate your insights!
Michael Kitches wrote the below quotation at https://www.kitces.com/blog/understanding-the-two-5-year-rules-for-roth-ira-contributions-and-conversions/ :
“the FIRST 5-year rule applies to Roth CONTRIBUTIONS and determines whether earnings will be TAX-FREE, while the SECOND 5-year rule applies to Roth CONVERSIONS and determines whether conversion PRINCIPAL will be PENALTY-FREE.”
You noted this example above in the post:
“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%.”
Should we apply the SECOND 5-year rule for your example since it’s a Roth conversion? If I didn’t misunderstand, should it rather be: Withdrawing this $12,000 within 5 years will have you pay a 10% penalty on the $12,000 (instead of just $2,000)? I assume the penalty would also apply to the conversion PRINCIPAL (if withdrawing before age 59.5)? Did I misunderstand, or miss something?
On the aforementioned link, Kitces seems to illustrate the penalty for withdrawing Roth conversion within 5 years applies to the conversion *principal* (not just on earnings) under sub-section “Intention Of The 5-Year Rules” – Example 2.
Would love to hear/learn your thoughts – thank you for your insight.
Harry Sit says
Kitces was talking about converting from a 100% pre-tax account. In my example, if the $12,000 came from a 100% pre-tax account, $12,000 was the “conversion principal,” i.e. the amount taxed at the time of conversion. When it was $10,000 after-tax money plus $2,000 pre-conversion earnings, only $2,000 was taxed at the time of conversion, and $2,000 was the “conversion principal.”
When you’re enrolled in Fidelity’s automated In-plan Roth Rollover, the pre-conversion earnings are zero or negligible, and therefore your “conversion principal” for the second five-year rule is also zero or negligible.
Jess says
Hi Harry, thank you for kindly clarifying on the “conversion principal” and answering my question so clearly.