Mega Backdoor Roth: Choose Wisely

Many of you are using the Mega Backdoor Roth, aka after-tax 401(k) contributions. It's a great way to make large contributions to a Roth account. Unlike a Roth IRA, there is no phaseout for high earners, and the dollar limits are surprisingly high (up to $47,500/year)!

As you may know, there are two options for executing the rollover transaction: roll into a Roth 401(k) or into a Roth IRA. The IRS allows either. The former can be automated, whereas the latter often requires phone calls to transfer funds, especially with Fidelity 401(k)s. So most people choose the former.

But, there are two main downsides to rolling into a Roth 401(k): 1. You're stuck with your 401(k)'s limited asset choices, which lack diversity and are sometimes quite expensive. 2. You usually lose the ability to optimize "asset location", i.e., choosing to put higher-growth stocks in the after-tax account, and lower-growth bonds in the pre-tax account.

Asset Location optimization for tax planning purposes typically results in greater net after-tax returns. Over a 30-year career, this simple decision could save over $100k in taxes. Makes sense, right? Why pay the same tax rate on everything? Why not put your high-growth assets where they won't get taxed? However, most plans require you to forgo that choice when using a Roth 401(k).

Is the ability to optimize asset location worth an extra hour or two of effort each year? I think it is, but either way, you should be aware of the pros and cons.