The Mega Backdoor Roth IRA

 

photo by Andrea Piacquadio via pexels.com

Rachel is a high earning soloprenuer.  While she’s already contributing the maximum to her pre-tax 401(k) plan, she still has a substantial amount that she would like to put towards her retirement but she makes too much to fund a Roth IRA and she’s not quite ready to start a cash balance plan. Rachel reaches out to a fiduciary financial planning firm for some guidance on how to maximize her money.

 

The financial planner mentioned that Rachel may be a good candidate for a “Mega Backdoor Roth IRA” option with her solo-401(k) plan. 

 

If that sounds like you, keep reading to find out how you could potentially get tens of thousands of dollars into a Roth IRA each year. 

 

Key Takeaways

 

• Mega Backdoor Roth’s allow you to contribute up to an additional $40,500 to a Roth IRA or 401(k) after maximizing your pre-tax or Roth annual contribution ($20,500 for under 50, $27,000 for 50+ regular employee contribution) in 2022.
• Your 401(k) plan must allow for after-tax contributions and in service withdrawals (or conversions) for a Mega Backdoor Roth to work
• The Mega Backdoor Roth is very specific, so not everyone will be able to use this strategy. Most firms with employees earning less than $130,000 in 2021 will not be able to make this work.

 

A Mega Backdoor Roth is a 401(k) strategy used to get extra savings into a Roth IRA account. Often used by high income solopreneurs and those with extra money to save, a Mega Backdoor Roth can be a powerful wealth building tool for the right business owner. 

 

*This article is general educational content and is not tax or financial planning advice. Speak with your financial planner or CPA before making any changes. 

 

Roth Basics

 

Because a mega backdoor Roth has many similarities to a regular backdoor Roth, it is important to understand how Roth accounts work. 

 

Contributions to a Roth IRA are made with money that has already been taxed and will grow tax free. Withdrawals from a Roth IRA that has been open at least 5 years are also tax-free after age 59.5, making the account an attractive vessel for retirement savings. However, an individual can only contribute $6,000 ($7,000 if 50 or older) to an IRA for 2022, and married couples who make more than $214,000 cannot contribute anything directly to a Roth IRA in 2022 (a single filer’s with a modified adjusted gross income over $144,000 are excluded from making a direct Roth IRA contribution). 

 

Individuals whose employers offer a Roth 401(k) are able to make Roth 401(k) contributions, up to the annual maximum of $20,500, regardless of their income. This may be a good option for those who cannot make Roth IRA contributions or want to contribute to a Roth account and are not utilizing their pre-tax 401(k) contributions.

 

The Backdoor Roth IRA

 

For high income earners who cannot make direct contributions to a Roth IRA (married filing jointly MAGI $214k+), the Backdoor Roth strategy can be very effective. To complete a backdoor Roth, one must make a non-deductible, or after-tax, contribution to a Traditional IRA. This contribution is then converted to a Roth IRA before it accrues any earnings, as any earnings converted would be subject to income tax. 

 

This is really important: you must not have *any* other pre-tax IRA money. You have to convert IRAs on a pro-rata basis. Don’t accidentally give yourself a nasty surprise come tax time. 

Tax filers who are pursuing a Backdoor Roth strategy need to make sure they file Form 8606 to document their non-deductible IRA contribution.

Contact your CPA or financial planner for more information regarding the possible taxability of a Backdoor Roth.

 

A backdoor Roth IRA is possible because, while direct contributions can be phased out, there is no income limit on who is able to convert money into a Roth IRA from a Traditional IRA. However, because of the contribution limits for IRA accounts, the backdoor Roth strategy is limited to a maximum of $6,000 annually ($7,000 for those over age 50). 

 

But why stop at $6,000 in a Roth IRA when you could save more? 

 

Enter: The Mega Backdoor Roth IRA

 

Where the Backdoor Roth strategy utilizes after-tax contributions to a Traditional IRA, the Mega Backdoor Roth consists of after-tax contributions to an employer sponsored 401(k) plan. These after-tax contributions are then quickly converted to a Roth IRA before any gains are accrued. 

After-Tax Contributions

 

After-tax contributions are contributions made with money that has already had FICA and income taxes withheld. These contributions do not reduce your taxable income like pre-tax contributions, and they will not be taxed when withdrawn from the account. However, gains on after-tax contributions are considered pre-tax money and will be subject to income tax when withdrawn.

 

Before you can make after-tax contributions to your 401(k) plan, you typically contribute the maximum employee contribution of $20,500 in 2022 (or $27,000 for those at least 50 years old) in either pre-tax or Roth dollars. Your employer (which may be you, boss) can also contribute to your account via a match or profit sharing contribution, up to a maximum of $61,000 in 2022 ($67,500 if you are 50 or older) including your contributions. 

 

What? Where is this $61,000 number coming from? Let’s get nerdy. 

 

Section 415(c) of the IRS code limits the entire contribution an employee and employer can make to a 401(k) plan on behalf of the employee. So while an employee is limited in 2022 to $20,500 (plus $6,500 in catch up contributions for the 50+ set), technically there’s another $40,500 that either you as the employee, or your employer can save on into that 401(k) account for your benefit.

 

For example: Laura is a 44 year old solo-prenuer and she’s absolutely slaying it. She saves $20,500 in employee contributions and her company makes a $20,500 profit sharing contribution. So far we’ve tallied $41,000 towards the Section 415(c) limit, which means that Laura could save up to an additional $20,000 in after-tax contributions to execute a mega backdoor Roth IRA.

 

Ok, back to our regularly scheduled programming:

 

If your employer does not contribute enough to reach the maximum $61,000, you may be able to make additional contributions on an after-tax basis. This is entirely dependent on your 401(k) plan document (known as a Summary Plan Description).  If you are not allowed to make after-tax contributions to your plan, then you will not be able to complete the Mega Backdoor Roth strategy. Which makes this strategy most appealing to high income solo-preneurs who control their own Summary Plan Document for their solo-k.

 

For 2022, the maximum amount of after-tax contributions you can make is $40,500, assuming your employer did not make any contributions. Often  your employer will contribute something to your retirement plan on your behalf, so follow these steps to determine how much you can contribute after-tax to your 401(k) plan. 

 

How To Determine Your Potential Megabackdoor Roth IRA

1. Get a copy of your 401(k) plan Summary Plan Description to see if After-tax contributions are allowed.
2. Determine the maximum that can be contributed to your account for the current year ($61,000 if under 50 in 2022).
3. Subtract your contribution amount from the maximum amount.
4. Subtract any employer contributions from the amount found in step two (match, flat contributions, profit sharing, etc.). This is the amount of after-tax contributions you can make for that year.

 

Why can’t I make after-tax contributions?

 

Employers with highly compensated employees, employees who own more than 5% of the business or who made over $130,000 in 2021 ($135,000 in 2022), may not offer after-tax contributions due to non-discrimination testing, which ensures that the 401(k) plan benefits everyone equally. If these highly compensated employees were able to make after-tax contributions, the plan may not pass the non-discrimination tests. If the 401(k) failed nondiscrimination testing, the plan would be forced to fix the cause of the failing status, or it would lose its qualified plan status and its favorable tax treatment for all plan participants. 

 

For more information regarding non-discrimination testing, please visit:

 

https://www.employeefiduciary.com/blog/401k-nondiscrimination-testing-basics. 

 

This is why a Megabackdoor Roth IRA is often best suited for a successful solo-preneur. 

In-Service Withdrawals or In-Plan Roth Conversions

 

Along with being able to make after-tax contributions, you will also need to be able to take in-service withdrawals from your 401(k) for the Mega Backdoor Roth. If in service withdrawals are allowed, you are able to rollover all or some of your account balance to a Traditional or Roth IRA.

 

If you are not able to make in service withdrawals, you may still be able to do a Mega-Backdoor Roth. If your employer allows for in-plan conversions to a Roth 401(k), you can simply convert your after-tax contributions to your Roth 401(k) with no taxes due. This is also used often for simplicity, as it may be easier than rolling the money to a Roth IRA in some cases. 

 

The Pro-Rata Rule

 

Withdrawals from a 401(k) plan are usually subject to the pro-rata rule, which governs how accounts with both pre-tax and post-tax amounts are handled. Specifically, if your 401(k) consists of both pre- and post-tax amounts, any withdrawal from the account must consist of a proportionate amount of the contributions. 

 

For example, if your account consists of $50,000 of pre-tax contributions and $50,000 of post-tax contributions, any withdrawal will consist of half pre-tax amounts and half post-tax amounts. 

 

Fortunately, the IRS allows for any pre-tax amounts to be rolled into a Traditional IRA while the after-tax amounts roll into a Roth IRA. Because of this, you generally must withdraw the entire account balance to withdraw the full amount of after-tax contributions made to the account. 

 

If your employer tracks the sources of your contributions separately, you may be able to take a partial withdrawal that consists of only the after-tax portion of your account. In this case, you could leave the pre-tax money in your 401(k) plan while still executing the Mega Backdoor Roth. 

 

If your employer allows for in-plan Roth Conversions, you could instead convert the after-tax contributions directly to your Roth 401(k) without having to withdraw the pre-tax portion of your account. 

 

Mega Backdoor Roth Considerations

 

If your plan allows for after-tax contributions and you are able to make in-service withdrawals, then you have the ability to complete a Mega Backdoor Roth. However, there are many considerations that play a factor in determining how applicable a Mega Backdoor Roth is to your situation. A few factors are:

 

• Have you already maximized your other savings options, like regular Roth IRA or 401(k) contributions?
• Have you met other financial obligations and needs? 
  • Consider paying down debt or saving for other non-retirement goals.
• Do you have extra money to save? 
  • Extra savings can come from many places, like income, inheritance, or gifts you have received.
• Should extra savings go in a taxable account or retirement account?
  • There are benefits to both taxable and retirement accounts, so you should determine where extra savings best fit before committing to any given strategy.

 

Speak with a Certified Financial Planner™ for help determining if a Mega Backdoor Roth is right for you. 

 

Mega Backdoor Roth Alternatives

 

Many individuals are unable to complete a Mega Backdoor Roth, either because their 401(k) plan does not allow for after-tax contributions and in service withdrawals or because it does not match their financial situation. Despite this, there are alternatives to this strategy that allow you to save extra for your retirement. 

 

• Contribute to a Roth 401(k) – A Roth 401(k) allows you to contribute after-tax dollars to your account. These contributions will grow tax deferred and will be distributed tax free. This will not allow you to contribute an additional large sum of money but will allow you to contribute up to $19,500 ($26,000 for those 50 or older) to a Roth account annually.

 

• Backdoor Roth IRA Conversion – If you are unable to complete a Mega Backdoor Roth or contribute to a Roth IRA, the Backdoor Roth IRA strategy will allow you to convert non-deductible IRA contributions to a Roth IRA. This strategy can be used simultaneously with 401(k) contributions to save a large amount throughout the year. Remember, the pro-rata rule applies here so it’s imperative you talk to your Certified Financial Planner ™ or CPA before executing this strategy.

 

• Save in a Taxable Account – While taxable accounts do not offer the tax-deferred growth that you can get in a retirement account, there may be benefits to saving in this type of account. There are no contribution limits on taxable accounts, and distributions can be taken at any time, meaning funds are available prior to retirement if necessary. 

 

Like many things, there is more than one way to save for retirement. If you are able to do a Mega Backdoor Roth, then you have a tremendous opportunity in front of you. However, if you cannot use a Mega Backdoor Roth to save, there are many other ways to ensure your financial stability in the future. Discuss your options with a Certified Financial Planner™ to find the best savings strategy for your situation. 

 

If you’re a high income solo-preneur interested in implementing a Mega Backdoor Roth IRA strategy, schedule a call.

 

Author: Bryce Thompson

Co-Author: Lauren Zangardi Haynes

Book a call