Mega Backdoor Roth: Part 1

One of the most frequently asked questions we receive is whether we can create a “mega backdoor Roth” inside a client’s 401(k) plan. While a lot of inquirers believe this is one simple box to check inside a plan, it in fact involves several steps and provisions that need to be carefully designed and monitored by the retirement plan’s TPA (such as The Pension Source). In this two-part series, we will go over what must happen. First, we will describe what a mega backdoor Roth is, and in our second post we will dive deeper into why we typically recommend it for only Solo 401(k)s or husband/wife plans.

In the world of retirement savings, the term “mega backdoor Roth 401(k)” might sound like a mouthful, but it holds significant potential for tax-efficient wealth accumulation. For those looking to maximize their after-tax retirement savings, understanding this strategy is paramount. Let’s dive into what exactly a mega backdoor Roth 401(k) is and how it works.

What is a Mega Backdoor Roth 401(k)?

Roth IRA and 401(k) accounts offer an individual the ability to receive tax-free income in retirement. Simply, the participant pays tax upfront and contributes post-tax dollars into the IRA or 401(k) on a Roth basis, and then does not have to pay tax upon distribution/withdrawal from such account at retirement. This can be incredibly attractive if the plan’s assets are able to compound over a long period of time. However, there are several “catches” to be aware of:

  1. For 2024, Roth IRAs are subject to an annual contribution limit of $7,000 ($8,000 if age 50 or older), and 401(k) plans are subject to an annual contribution limit for Roth deferrals of $23,000 ($30,500 if age 50 or older)
  2. Roth IRAs are subject to an income limit, meaning that high-income earners are not allowed to contribute at all (401(k) plans are not subject to such limit though)

So what is a high-income person supposed to do if they want to access the benefits of a Roth account? A mega backdoor Roth 401(k) is the answer. By working with a high-quality TPA, the maximum mega backdoor Roth 401(k) amount an individual can contribute is $69,000 (or $76,500 if age 50 or older), which is the IRS annual additions limit for 2024. It solves the problems of the income phase-out associated with Roth IRAs and the low annual contribution limit of $23,000 for Roth deferrals under a 401(k) plan. As a result, it can be an incredibly powerful wealth accumulation strategy, and is the reason why we get so many questions about this strategy.

How Does it Work?

First, contact a retirement plan TPA such as The Pension Source to see if you are a good candidate for this strategy (note, in part 2 of this series we will discuss why businesses with employees make this strategy challenging). After confirming you are a good candidate, the 401(k) plan will be designed with the following features:

  • Max Out Elective Deferrals on a Roth basis:
    The first step in executing the mega backdoor Roth strategy is to ensure that the 401(k) plan allows for elective deferrals to be made on a Roth basis, and then to maximize contributions up to the annual contribution limit of $23,000 (or $30,500 if age 50 or older) on a Roth basis.
  • Contribute Additional After-Tax Dollars through Voluntary Contributions:
    The second step in is ensure that the 401(k) plan allows for voluntary after-tax contributions. Once the elective deferrals are maxed out for the year (i.e., $23,000 (or $30,500 if age 50 or older)), individuals can elect to make voluntary after-tax contributions up to the difference between the IRS annual additions limit for the year and what the individual has already contributed for the year. For example, an individual who is age 45 and who has already made elective deferrals of $23,000 for 2024, may make voluntary after‑tax contributions of up to $46,000 (which is $69,000 – $23,000) for 2024.
  • Convert After-Tax Voluntary Contributions to Roth:
    This last part is crucial. The 401(k) plan must allow the participant to convert the voluntary after-tax contributions to Roth as soon as possible to minimize the tax on any earnings on the voluntary after-tax contributions. A 401(k) plan can offer two options: (i) in-plan Roth rollover and/or transfer (i.e., the voluntary after-tax contributions are converted to Roth within the 401(k) plan) or (ii) in-service distributions of voluntary after-tax contributions (i.e., the participant receives an in-service distribution of voluntary after-tax contributions from the 401(k) plan and rolls over the distribution to a Roth IRA).

After you’ve completed the three steps above, you will have contributed $69,000 ($76,500 if age 50 or older) to your retirement plan on a Roth basis and get to enjoy years of tax-free compounding and eventually withdrawals.

Benefits of a Mega Backdoor Roth 401(k)

Tax-Free Growth

By converting voluntary after-tax contributions to a Roth contribution, individuals can enjoy tax-free growth on their investments, providing a valuable source of tax-free income in retirement.

Flexibility

Unlike traditional Roth IRA contributions, which are subject to income limits, the mega backdoor Roth strategy is available to high-income earners, offering an additional avenue for tax-advantaged retirement savings.

Estate Planning

Roth IRAs offer unique estate planning benefits. Beginning in 2024, Roth accounts in a 401(k) plan are not subject to RMDs during the participant’s lifetime.  This allows for greater flexibility in passing on assets to heirs.

Considerations and Caveats

Plan Rules and Regulations

The ability to execute a mega backdoor Roth depends on the specific rules and regulations of your employer-sponsored retirement plan. Not all 401(k) plans allow voluntary after-tax contributions or in-service withdrawals for Roth conversions, so it’s essential to consult with your TPA and make sure they know how to design the plan appropriately.

Tax Implications

The timing of converting voluntary after-tax voluntary contributions into a Roth 401(k) or IRA could potentially have adverse tax implications. It is critical that you work closely with your TPA and CPA at this step.

Professional Guidance

Given the complexities and nuances involved in implementing a mega backdoor Roth strategy, seeking guidance from a qualified TPA and tax professional is highly recommended.

SECURE 2.0 May Change This Option Soon

Lastly, SECURE 2.0 has several changes related to Roth provisions and there have been repeated calls by Congress to disallow mega backdoor Roths going forward. We’d be happy to discuss these further with you.

In conclusion,

The mega backdoor Roth offers high-income earners a valuable opportunity to accumulate wealth in a tax-efficient manner. By understanding the mechanics of this strategy and navigating the associated considerations, individuals can take proactive steps towards building a more secure financial future. We’d love to have a discussion with you about tailoring a tax-advantaged retirement plan to your liking. Our passion is improving retirement outcomes for small business owners and their employees.

Reach out if you’d like to learn more at [email protected].