Mega-Backdoor Roths Aren't Just For "Rich" People
/When many people learn about mega-backdoor Roth 401k contributions, they think to themselves, “this sounds like a great strategy for “rich” people”. Sure, it can be a lot easier for someone with a very high income to afford a $60,000 or $70,000 contribution every year and high earners are definitely a group that can benefit hugely from the mega-backdoor. But, there are two things I’d like to point out:
A lot of income doesn’t necessarily translate into a lot of disposable income or savings. Without the right money habits, people tend to spend more as they earn more and can even end up feeling like they have less of a cushion than they did when they earned less.
Income is just one part of a larger financial picture. Too many people never think beyond income and their basic 401k contribution to consider ways their savings, assets, debt, and expenses interact with and can complement those basic building blocks.
You could write an entire book on point #1 but I want to focus on point #2 with five examples of relatively common situations where, when you look at the whole picture, mega-backdoor contributions are attainable and can make a lot of sense, at least in a given year or time period. If you don’t have a clear idea of what your “whole financial picture” looks like, please reach out, that’s exactly what I’m here for.
You have a self-employed spouse. While there are several retirement account types available to self-employed individuals (we set these up often for new clients), many people either aren’t aware of them or feel it will be too complicated to set them up. In this situation it makes sense to think about your combined income and turn the spouse who does have access to a 401k into the super-saver of the family. If one spouse has no account to save for retirement, it can be pretty feasible for the other to be able to max out their 401k contribution and then use the mega-backdoor to boost savings even further.
You have extra cash after selling a home. With the massive increase in home prices some people are finding they’ve accumulated enough equity to have cash left over, even after making their down payment on a new home. Often people are unsure what to do with this cash and will let it sit in the bank earning nothing. Some may at least take the step of investing it so it can grow. But, that growth will be taxed. In this situation, maxing out a 401k and then making a mega-backdoor roth contribution is an ideal way to essentially shift that money into a tax-free account where it can grow and never be taxed again!
You have more in the bank than you need for your emergency fund. This could be a sign that you’ve been under-saving for retirement. If so, maxing out your 401k for a year or two and making extra mega-backdoor contributions is a great way to catch up, get that money growing, and avoid tax on that growth. If you have been saving enough and are still in this boat, layering on mega-backdoor contributions could help get you to retirement or financial independence sooner than you thought possible.
You had a windfall or unusually high compensation this year. Most people don’t win the lottery so more often this could be an inheritance, a gift from a family member, an unusually large bonus at work, a stock grant, or an unusually “good year” for commission-compensated workers. Often in these situations the income is unexpected and therefore not already “spoken for”. If you want to avoid the temptation of spending it just because it’s there, a mega-backdoor contribution is a great way to essentially shift this money to an account where it can grow tax-free.
You moved or made a life change that has reduced your expenses dramatically. As remote work exploded during the pandemic, some people have been able to keep jobs with “big city” or “coastal” pay while moving to areas of the country with a much lower cost of living. Others may have moved in with aging parents to help care for them and have seen their living costs plummet as a result. Maybe kids moved out or finished college that you were paying for. While maxing out your 401k may have been unobtainable before, it may now be a very real option to consider along with going even further and making mega-backdoor contributions.
There are many more examples of situations where mega-backdoor roth contributions can be unexpectedly relevant but there are some overarching themes:
When the amount of money coming in during a year is significantly higher than usual.
When your expenses are significantly lower than usual but your income hasn’t changed.
When you’ve built up more savings than you need for your emergency fund and short-term goals.
When one spouse has access to a 401k and the other working spouse does not.