Mega Backdoor Roth

Roth assets are becoming more and more essential to a successful retirement savings strategy. Concerns about rising tax rates and legislative changes (ex. SECURE Act eliminating the stretch IRA) are two important drivers.

Let’s start with the basics of “Why Roth?” 

• Contributions are after-tax
• Tax free growth of principal and earnings
• Tax free withdrawals* 

*after satisfying 5 year rule, age 59 1/2

Unfortunately Roth IRA contributions are limited to $6,000 ($7,000 for age 50+) and many individuals are not eligible based on income limitations.

If an individual is looking to build up their Roth assets they should look no further than their employer’s 401(k) plan. Here are three ways to do so:
     1.    For 2021 Roth 401(k) Salary deferrals of up to $19,500 ($26,000 for age 50+).
     2.    In plan Roth conversions  
     3.    The Mega Backdoor Roth

Important note: Income limitations do NOT apply in a 401(k) plan. This applies to everyone!

Let’s focus on the Mega Backdoor Roth strategy as this is the one we get the most questions about. This strategy allows an individual to save up to an additional $38,500 in a Roth 401(k)/Roth IRA in 2021.

In order to execute the Mega Backdoor Roth strategy your employer’s 401(k) plan must allow for after-tax (non Roth) contributions and in-service withdrawals and/or in-plan Roth conversions. Of course it would make sense for the plan to already offer Roth 401(k) contributions.

After-tax (non Roth) contributions are a separate money type within a 401(k). They are an additional savings bucket to Traditional (pre-tax) and Roth (after-tax) salary deferrals.

Here are the mechanics of the Mega Backdoor Roth:

Step 1
Make an after-tax (non Roth) contribution.

Step 2
Roll the after-tax dollars (via in-service withdrawal) to a Roth IRA.

-or-
Convert the after-tax dollars (via in-plan conversion) to your Roth 401(k)

In 2021, the maximum employer plus employee contribution is $58,000 ($64,500 for age 50+). To determine the maximum after-tax contribution allowed you need to subtract out any 401(k) contributions made and any employer match/profit sharing. This calculation may require that you estimate what your employer will contribute.

For example:

A 45 year old 401(k) participant that contributed $19,500 and received a $3,000 employer match would be able to make up to a $35,500 after-tax contribution ($58,000-$19,500-$3,000). That’s a whopping $35,500 possible in Roth savings after the strategy gets executed!

Will or should all companies offer the Mega Backdoor Roth? In many instances, the addition of the after-tax contributions will prevent a plan from passing non-discrimination tests. This is because the IRS limits how much money highly compensated employees can contribute as compared to the contributions made by other employees who are not highly compensated. As non-highly compensated employees generally cannot save more than the traditional 401(k) limits, most plans would not be able to pass the non-discrimination tests if only the highly compensated employees take advantage of the Mega Backdoor Roth. This testing of after-tax contribution applies even to Safe Harbor Plans so it is important to look at the demographics of the company when deciding if the Mega Backdoor Roth makes sense for the company’s plan.

Another important note:We are in a plan restatement window. That means all 401(k) plan documents written prior to August 2020 must be restated. This is an opportune time to add Roth contributions, in-plan Roth conversions, in-service withdrawals, and after-tax capabilities to a plan document.