The Fabulous MBR (Mega Backdoor Roth)
Reaching financial independence (FI) is a race. It’s not a race against anyone else, but a race against something far more formidable: time. You have a limited number of days on Earth, and quite frankly, you are expiring with every passing hour. The faster you can reach FI, the more time you will have to do what you want the most. Reaching FI is not an easy task, however, and you should take advantage of any available tools and strategies.
One of the best available tools to save for retirement is the 401(k) account. As mentioned in my last post, a 401(k) plan can save you tens-of-thousands of dollars in tax, and speed the process of reaching FI. But recall that the IRS imposes an annual cap on contributions to limit the tax savings. That limit is $19,500 in 2020 and 2021. If you are 50 or older, you get an additional $6,500 as a catch-up contribution, so you can contribute up to $26,000.
Given that my recommendation is to save at least 20% for retirement, that means anyone with a salary north of $100,000 should be maxing out their 401(k) accounts each year.
But what about the higher income earners?
I work with employees at tech companies such as Facebook and Google, where the median income in 2018 was $228,000 and $246,000, respectively. Software engineers in Silicon Valley easily make above $200,000, and many of my clients make well north of $500,000.
Employers at Facebook and Google, as well as Apple, Microsoft, Synopsys, Genesys, Cisco, Salesforce and more, are taking notice and are opening up opportunities to save more in their 401(k) plans through after-tax contributions.
After-tax contributions allow you to contribute more than the $19,500 limit, up to a lesser known limit of $57,000 in 2020, and $58,000 in 2021. This limit is inclusive of the $19,500 pre-tax or Roth contribution, plus after-tax, and employer contributions. Without an employer match, employees at these companies have the option to save an additional $37,500 in 2020 and $38,500 in 2021 in their 401(k) accounts.
MBR Mechanics
After-tax contributions are initially put in an “after-tax” bucket, and in order to complete the “mega backdoor Roth” contribution, it requires a second step of transferring it to the Roth bucket. Despite the funky two-step process, the tax advantages is the same as if you put the money directly into a Roth account.
There are two options when it comes to transferring the after-tax contribution to a Roth account. The first is to transfer it to your Roth 401(k) with the company. The alternative option is to transfer it to an external Roth IRA. The main advantage of transferring it to your company’s Roth 401(k) is the convenience as many companies will automatically transfer any after-tax contributions to the Roth 401(k).
Transferring your after-tax contribution to a Roth IRA is a manual process, but the big advantage is that Roth IRA’s have more friendly withdrawal rules. Contributions to a Roth 401(k) have strict withdrawal rules, and typically cannot be withdrawn until you separate from the employer and you are over 59 ½ years old. The amount transferred to a Roth IRA, however, can be withdrawn for any reason and without penalty, as long it’s been in the account for 5 years.
Quantifying the MBR
Let’s use an example to quantify the benefits of MBRs:
Ben and Karl are both 30-year-old engineers in San Francisco with income of $285,000. They share a goal of retiring at age 50 to travel around the world. They both max out their traditional 401(k) at $19,500 and receive a match of $5,000 from their respective employers. Ben’s employer allows after-tax 401(k) contributions, so he saves an extra $32,500 and transfers it to his Roth IRA. Karl’s employer does not allow after-tax 401(k) contributions, so his only alternative option is to save his extra $32,500 in a regular brokerage account. Ben and Karl repeat this process over the next 20 years, and their accounts grow annually at 8%.
At age 50, the expected value of each of their 401(k) accounts is $1,121,168. There is no difference here. The value of Ben’s Roth IRA account at the end of 20 years is $1,487,263, while the value of Karl’s regular brokerage account is $1,189,270. Let’s break down how we Ben ended up with almost $300,000 more than Karl by utilizing the MBR.
Without the option to make after-tax contributions, Karl saved in a regular brokerage account where dividends, interest, and capital gains are taxed every year. As a result of these taxes, his account only grew at 7.5% to $1,407,402. Furthermore, selling investments to withdraw cash from a regular brokerage account will incur capital gains taxes. The capital gains tax rate for high earners can be as high as 23.8%, and Karl also needs to pay California state tax on the gains. Assuming an average CA tax rate of 5%, Karl’s brokerage account after capital gains tax is worth $1,189,270. Capital gains also increases your adjusted gross income (AGI), and higher AGIs can lead to higher tax on Social Security benefits and higher Medicare premiums, so Ben’s advantage over Karl will likely be over $300,000 when all is considered.
Final remarks on the MBR
Even though Ben and Karl saved the same $32,500 each year, Ben has more than $300,000 for retirement because he was able to utilize the MBR. Put a different way, it would take over 9 years for Karl to save an extra $300,000, meaning Ben was able to shave 9 years off of his working years. 9 more years Ben can travel around the world, 9 more years to spend time with his family, 9 more years to volunteer at his favorite charity, just 9 more years to start a business with a longtime hobby, or 9 more years to simply relax.
FI gives you the option to get the most out of your life, and because your life is finite, every year you are not financially independent is a year you lose from doing what you want most. Leverage tools like the MBR can help you reach FI faster, with no extra work on your part, simply due to saving taxes.
If you are interested in working with me to explore other strategies to reach FI, schedule a free 15-minute consultation using the link below.
