In a previous post, I wrote about the basics of both Traditional and Roth IRAs. At the time, that was all I cared about knowing, since I hadn’t yet started my full-time job (and so there was thus no reason to worry about what a 401(k) was, or about Roth IRA income limits). Seeing as I now understand a bit more about retirement accounts, I’ll give my best effort at trying to clarify some of the things that I’ve learned so far.
what’s a 401(k)?
Assuming that you’ve read my previous post, it’s a tax-advantaged account very similar to an IRA. Like the IRA, the 401(k) comes in Roth and traditional flavors that function similarly - the Roth 401(k) contributions are made with post-income-tax money, while traditional 401(k) contributions are made with pre-income-tax money (that is then taxed at withdrawal). Growth within the account, however, is tax-free, so you won’t pay capital gains taxes on assets within your 401(k). Like IRAs, there’s an annual contribution limit, though the amount is different: $19,500 for 2021 (though I’ll explain below how the “mega-backdoor Roth” can make this much higher). Unlike IRAs, 401(k) plans, Roth and Traditional, have no income limit.
The key difference is that it’s offered through your employer, as opposed to an IRA where you’re totally in control. This means that contributing to your 401(k) is done via a deduction on your paycheck, as opposed to you depositing money from one account into another [1]. It also means that the different securities you can invest in may be limited. Finally, there’s the possibility of employer matches coming into play - basically free money from your employer when you contribute to a 401(k). The exact specifics of the 401(k) vary from plan to plan, which means that they vary from employer to employer. My employer’s plan, for example, offers both a Roth and Traditional 401(k) option, has no matching, allows me to contribute up to 75% of my paycheck into my 401(k), and only allows me to invest in a handful of funds from Vanguard (at least there are good, low-fee options available).
the Backdoor Roth
The backdoor Roth refers to a two-step process by which you can contribute money to a Roth IRA, even if you’re over the income limit - first by contributing to a traditional IRA, then by converting your traditional IRA balance to a Roth IRA. There are a few considerations, though this article is a helpful resource for the process. Each year you use the backdoor Roth, you’ll have to fill out Form 8606.
the Mega-backdoor Roth
The mega-backdoor Roth is a process by which you can drastically increase how much you contribute to a Roth 401(k) - up to $58,000 (in 2021). Despite the similar name, it’s actually a completely separate process from the “normal” backdoor. Because 401(k) plans vary from company to company, it’s impossible for me to give specifics on the exact process, and in fact it requires that your company offer a third kind of 401(k) called an after-tax 401(k) account (that’s separate from the Roth 401(k), which is also an after-tax 401(k) account) - I’ll call this the “non-Roth after-tax 401(k)”. At a high level, the general process is:
Contribute to your non-Roth after-tax 401(k).
Convert your non-Roth after-tax 401(k) into a Roth 401(k).
This article is quite helpful for learning more.
[1] Suppose that I have $1,000 that I’d like to invest for retirement. While I can deposit this money into an IRA, I can’t do this with a 401(k). I must have that amount deducted from my salary. I graduated college in May and started my job in August, which meant that I had only 5 months during which I could allocate a portion of salary to my 401(k). Depending on my salary and on the maximum amount that my employer would let me contribute, I might not have been able to hit the 401(k) annual contribution limit.
I am not providing or intending to provide tax, legal, or accounting advice. This blog post is for informational purposes only, so please don’t rely on it for tax, legal or accounting advice. Consult your own tax, legal and accounting advisors before engaging in any transaction. I’m just a guy on the internet. Please don’t sue me.