You know I love efficient tax structures. That’s why the so-called Mega Backdoor Roth IRA happens to be one of my personal favorites.
The opportunity to make after-tax contributions isn’t new. But recent IRS regulations on rollovers now make these contributions much more attractive.
In this post, we will provide a detailed review of the Mega Backdoor Roth IRA and offer up some tips and tricks to make it work for you. Let’s jump right in.
Table of contents
- What is a Mega Backdoor Roth IRA?
- So What Does the IRS Say About This?
- Why would I want to make after-tax contributions?
- How is this different than a Roth 401k?
- What is the downside or disadvantages of a Mega Backdoor Roth IRA?
- A Review of the Solo 401(k)
- The Mega Backdoor Roth IRA in a Solo 401k
- Mega Backdoor IRA Examples
- What about Schwab, Fidelity and Vanguard?
- The 5 Easy Steps
- Setting up a Mega Backdoor Roth
- Is a Mega Backdoor Roth Worth It?
What is a Mega Backdoor Roth IRA?
The structure itself is pretty straightforward. It allows 401k participants to make an annual contribution of “after-tax” dollars in a specified dollar amount that will bring their total annual contribution for a given tax year up to the annual limit. These amounts can then qualify for tax free distributions to a Roth IRA or an “in-plan” or “in-service” Roth rollover.
Once the participant makes the maximum annual after-tax contribution, these contributions can either be rolled out of the plan into a Roth IRA or converted to Roth assets in an in-plan Roth rollover. If the Roth IRA compliance requirements are in place, the participant can receive these contributions tax free. Not such a bad deal.
So What Does the IRS Say About This?
There had been debate in the industry about the mechanics and legal aspects of this structure. The IRS had taken a general stance, but offered little guidance on the implementation.
But then the IRS essentially blessed this approach with a few caveats. After many years of fighting the structure and arguing that the pro-rata rule would apply to such conversions, the IRS has issued guidance (IRS Notice 2014-54).
This guidance essentially reversed its prior position and allows taxpayers to roll over their 401(k) amounts and allocate pre-tax funds amounts to a traditional IRA and after-tax amounts to a tax-free Roth conversion.
Why would I want to make after-tax contributions?
Tax-deferred compounding has always been one of the biggest benefits to retirement planning. With no tax paid on dividends, interest and capital gains generated in the plan, overall returns will significantly increase.
But with a Mega Backdoor Roth IRA, investors are allowed to direct more assets into a Roth than they otherwise could. The funds can begin compounding on a tax-free basis once the rollover is finalized. Any withdrawals will be completely tax-free.
One additional benefit – Roth IRAs are not subject to required minimum distributions (RMDs). This is great for investors approaching retirement who have concerns about RMDs.
How is this different than a Roth 401k?
But don’t confuse after-tax contributions with Roth 401k employee contributions. Both do involve after-tax dollars. But there are a few key differences.
First of all, Roth 401(k) contributions are subject to the annual employee 401k deferral limit of $19,500 and $26,000 (for people 50+ years of age). However, after-tax 401(k) contributions could be substantially higher just so that the total annual 401(k) contribution does not exceed $58,000 (or $64,500 for people 50+ years of age) for 2021.
What is the downside or disadvantages of a Mega Backdoor Roth IRA?
This all sounds great, right? But as with any structure, there can be pitfalls along the way that can get you into trouble.
There are a few little know concerns. But once you understand them you can dive in. Let’s take a look.
Not every 401(k) plan allows it
This first one can present a problem with your current 401(k). Even though it is legal, your 401k plan document may not allow for after-tax contributions.
Many investors have plans with providers like Schwab, E-Trade, TD Ameritrade, Vanguard or Fidelity. Some of these providers have very basic plan documents. They do not contain many of the robust features that other plan providers offer.
Why is this the case? Because you are typically not paying anything for the 401k document itself (or very little). In addition, you are not paying large annual fees for administration.
The custodians are making money off your investment account itself. As such, they don’t want to make it easy for you to transfer out your funds. The result is you get a bare bones plan document.
Allocating funds can be a little painful
While it may seem simple at first, the process of allocating funds between pre-tax and after-tax can be a challenge.
The funds will have to be allocated on a pro-rata basis if the investor takes out only part of the account. For example, let’s assume a 401(k) balance is $50,000 and includes $10,000 of after-tax funds. If the individual only takes a $10,000 distribution, it is treated as $8,000 of pre-tax and $2,000 of after-tax.
But if the owner wants to get all of the after-tax funds into a Roth, he or she would have to take all $50,000 from the 401(k) plan. This would require $40,000 to go to a rollover IRA and $10,000 to go into a Roth.
Said differently, investors cannot just take a distribution of the after-tax amounts and keep the pre-tax amounts in the plan. Any partial distribution must include some of the pretax amounts.
Each distribution must be allocated with a proportional share of the pre-tax and after-tax amounts. So the easiest approach is to take a full distribution. Just roll over the pretax funds to your traditional IRA and the after-tax amounts to a Roth IRA.
Here is another hurdle that trips people up with a Mega Backdoor Roth. This strategy, while straightforward in theory, is difficult to implement when there are employees other than just the owner. This results from the nondiscrimination rules.
For plan testing, any after-tax contributions will be included even though the plan document many contain a safe harbor contribution. Specifically, this is called the ACP test. This part gets a little technical. But plans with non-highly compensated employees (NHCEs) will normally fail the ACP test. This is because the NHCEs will most likely not contribute enough (if any) after-tax contributions to the plan to allow highly compensated (HCEs) to essentially max out after-tax contributions.
The result is that the Mega Backdoor Roth IRA will be best for owner-only plans (solo 401ks). If you have additional employees, make sure to discuss with your administrator upfront to make sure the plan will work.
After-tax earnings are NOT allocated to the Roth
People often think that after-tax means Roth. But the tax treatment of Roth 401(k) contributions and after-tax contributions is very different.
Any earnings on Roth 401(k) contributions start to compound immediately on a tax-free basis. However, when after-tax contributions generate investment earnings (dividends, interest, etc) inside the 401(k), those earnings will compound on a tax-deferred basis. This is NOT on a tax-free basis.
The Roth IRA can accrue tax free earnings when the after-tax funds are rolled over. Accordingly, the employee will have had to retire, leave the company, or take an in-service distribution from the plan.
The pretax portion of the 401(k), which includes the contribution and related earnings can only be rolled into a Traditional IRA. Taxes are due if these funds are transferred to a Roth IRA.
But the new IRS guidelines do make after-tax contributions more attractive. In addition to the tax-deferred compounding, the new IRS rules allow for the segregation of the after-tax funds from the pretax funds at the time of IRA rollover.
A Review of the Solo 401(k)
We have discussed the fact that a Mega Backdoor Roth IRA will work best in a solo 401(k). This relates to nondiscrimination testing issues. But is a Mega Backdoor Roth worth it?
Whether self-employed or employed as an independent contractor, consultant, through an LLC, partnership, corporation entity or even a sole proprietor, your retirement plan of choice has to be a Solo 401(k). This is because Solo 401k plan has irresistible advantages including:
- It offers high contributions.
- It offers loans to participants.
- Has a wide portfolio of investments like real estate, precious metals, tax liens, trust deeds, and company shares.
To qualify, one has to comply with two eligibility requirements; self-employment activity whether part-time or full-time and without any common law to full-time employees.
Self-Employment Activity (for a Mega)
The self-employment activity must pursue steps to make a profit, that is, to generate an income, whether through an LLC, C-Corporation, S-Corporation, or Sole Proprietorship. Partnership or sole proprietorship income is considered earned income. However, S-Corporation pass-through income is not classified as earned income for retirement purposes.
A guaranteed payment from self-employment made to a limited partner is treated as net earnings as long as the payment is made for services provided to the partnership.
If your intention is not to pursue self-employment income, then you should not open a Solo 401k plan. IRC section 402 (a) defines earned income to mean individual’s net earnings from self-employment activities in a trade or business.
The defined earned income should arise from an individual’s personal services, and the said service should be a material income-producing factor.
The main purpose of the earned income rules from self-employment activity is to provide a Solo 401k plan for the self-employed so they can save for their retirement.
Solo 401(k) plans are for owner-only businesses that have no full-time employees. However, the owner can still qualify for a Solo 401(k) if he or she has the following types of W-2 employees:
- Employees under age 21
- Employees working part-time (less than 1,000 hours annually)
- Union employees (typically not a big problem)
- Non-resident alien employees
The Mega Backdoor Roth For Your Spouse
Solo 401(k) plans are for business owners and spouses. As such, the spouse is eligible to participate as long as he or she works in the business. There should be no additional fees or charges when spouses participate in the same Solo 401k plan.
The Mega Backdoor Roth IRA in a Solo 401k
So let’s take a quick look at how this strategy can work for a small business owner with no employees. First let’s take a look at the IRS limitations:
|Tax Year 2023
|Deferral (under 50)
|Deferral (over 50)
|Annual Limit (under 50)
|Annual Limit (over 50)
Let’s first assume that a 40 year old business owner has an S-Corp and issues a W2 for $100,000. With a solo 401k, he or she can have an employee deferral of $19,500 and then make a profit-sharing contribution of $25,000 (25% of the W2 amount).
But remember the limit will be $66,000. In this example, the owner will be short of the annual cap. But if the business owner has a plan that allows after-tax contributions AND in-service withdrawals, they can make a larger overall contribution. Let’s look at the final contribution below:
- $23,000 in employee elective contributions (shown on the W2)
- $25,000 in 401(k) profit sharing contributions
- $21,000 in after-tax contributions
As you can see, the full contribution meets the annual cap. The after-tax contribution can then be rolled over as a Mega Backdoor Roth IRA. That’s a big overall contribution if someone is looking to maximize the contribution.
You can open a Solo 401(k) plan by December 31st if you are to make contributions for this year. You need your Employer Identification Number, complete plan adoption agreement and to set up contribution. Your broker will provide access to different investments they offer.
You may have to file an annual report with the IRS (Form 5500–EZ). This is only if your 401(k) plan accumulates $250,000 or more in assets at the end of a given year.
Mega Backdoor IRA Examples
So now that you understand the basics, let’s take a look at a couple real life examples and strategies that we use for clients. Hopefully, these will work well for you in your situation. Be sure to check with Vanguard, Fidelity or Schwab to help if you have accounts set up with them.
Strategy #1: The Combo
Of course we are known for our cash balance plans. Most of our clients who use the Mega backdoor strategy combine it with a cash balance plan. That way they get the best of both worlds: large tax deferrals combined with Roth contributions. So let me walk you through one client’s situation.
This client was a 48 year old physician (pathologist) who does contract work with a hospital and has no employees. His annual income after deducting business expenses was approximately $500,000 and his business was structured as an S-Corp. His goal was to maximize his cash balance plan, but also to max out the Mega.
Many people don’t realize that you can combine a Mega Backdoor with a cash balance plan. You certainly can and we do it all the time. There are just a few limitations. Here’s how it worked for this client:
- W2 compensation (from his S-Corp) = $200,000
- 401(k) employee deferral = $23,000
- 401(k) profit sharing = $12,000
- 401(k) after-tax = $34,000
- Cash balance plan contribution = $168,450
- Total retirement contribution = $226,450
So looking at the above example, there are a few things I wanted to point out:
- At first glance many people state that the 401k profit sharing contribution should be 25% of the W2 (subject to the cap). This makes sense for a stand alone plan, but NOT for a combo plan. When a 401k is combined with a cash balance plan the profit sharing is limited to 6% of the W2. This is one restriction when combining plans.
- You will see that the combined 401k amounts equal $58,000. The $26,500 after-tax portion should be immediately rolled over to a Roth.
- The cash balance plan contribution of $168,450 and the $12,000 are deducted directly on the S-Corp tax return and the $23,000 will be a reduction on the W2 and reflected in box 12.
- The tax deductible combined contribution is $199,950. Assuming a combined federal and state tax rate of 40% this is a tax savings of approximately $80,000.
This example demonstrates how powerful a combined plan can be. You get the tax deferral of the cash balance plan combined with the Mega Backdoor Roth allocation. It is really a win-win.
Strategy #2: The Low Bracket
This next example is a little unusual. We don’t typically deal with clients in low tax brackets. However, everybody needs a retirement plan no matter how much money you make.
This client was 62 years old and getting close to retirement. His income was approximately $100,000 and he has an S-Corp. He is married and his wife did not work.
When you look at the federal tax brackets, you will find that the top end of the range is approximately $78,000 for married filing joint. Adjusting for the standard deduction or assuming small itemized deductions, a married couple can make around $100,000 and still be in the 12% bracket. Most of our clients will take the 12% tax bracket all day long.
So when you are in a low bracket do you really need tax deductions? They certainly help but are not as important as they are for someone in the 37% bracket. I would generally propose that you would max out your Roth contributions and after-tax contributions and pay your tax at the 12% marginal rate. This sounds like a fair trade off. So here is his situation:
- W2 compensation (from S-Corp) = $65,000
- 401k employee Roth deferral = $23,000
- 401k profit sharing = none
- 401k after-tax = $38,500
- Total retirement contribution = $64,500
This example is very different, so let’s consider a few points:
- The combined 401k amounts equal $64,500. Because he was over 50 years old, he gets an additional $6,500 “catch-up” contribution.
- The employee deferral of $26,000 is actually a Roth 401k contribution and does not go into the tax deferred bucket. It is still noted on box 12 of the W2, but will not be a salary reduction.
- As stated, you can see that getting a tax deduction was not his motivation. So if you are in a low bracket and don’t need the money the tax-free route can be a great option.
What about Schwab, Fidelity and Vanguard?
I discussed previously the fact that 401ks set up with Schwab, Fidelity and Vanguard may not be compatible. I have had clients come to use specifically looking for a Schwab Mega Backdoor Roth or a Vanguard Mega Backdoor Roth. It is challenging to stay on top of all the various plan administrators and custodians.
But the point is that they are in place mostly for custodial purposes. They may not understand the nuances on how these plans work.
The 5 Easy Steps
Now that you understand how it works, let’s take a look at 5 simple steps so that you can put it into place. We will assume that you are a business owner with no employees.
Setting up a Mega Backdoor Roth
- Verify that it is currently allowed under your plan document. Make sure that your current plan document allows after-tax contributions and in-service distributions. If not, you may request a plan amendment or simply set up a new plan.
- Determine how much you actually want to fund. You can go up to the annual limits. But you may certainly do less as long as you have enough earned income.
- Consider the proper mix. Determine the desired break down between Roth 401(k), traditional 401(k) and the after-tax portion. Each person has their own comfort zone.
- Don’t forget to fund the account. Make the desired contributions. Make sure they are coded correctly at the custodian and on the W2 (if applicable).
- Complete the in service distribution. This is often the toughest part. Again, the amounts should be properly coded. Don’t run into problems come tax time.
Is a Mega Backdoor Roth Worth It?
The Mega Backdoor Roth IRA is a great retirement strategy. The after-tax contributions effectively become Roth IRA contributions. Just make sure the plan allows for them and the proper steps are followed. This gives savers greater access to Roth contributions than if they relied strictly on direct Roth 401(k) and IRA contributions. But you have to make sure that you navigate the potential pitfalls.
At Emparion, our plan documents allow both after-tax contributions and in-service distributions at any time. While this design is permitted, make sure that you take a close look to make sure you don’t have any problems. There are a few risks that must be mitigated with this great structure.