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. In our first post, we described a mega backdoor Roth, and in this second post we will dive deeper into why we typically recommend it for only Solo 401(k)s or husband/wife plans.
As touched on in the first post, the mega backdoor Roth includes three main steps:
- Maximize 401(k) elective deferrals on a Roth basis
- Contribute voluntary after-tax contributions up to the IRS annual additions limit
- Convert voluntary after-tax contributions to Roth, either inside the 401(k) plan or to a Roth IRA
The Problems
Step 2 of this process is where most companies that have both Highly Compensated Employees (HCEs) and non-Highly Compensated Employees (NHCEs) run into problems. In general, HCEs are more likely than NHCEs to make voluntary after-tax contributions to a 401(k) Plan. Voluntary after‑tax contributions and matching contributions (if any) made to 401(k) Plan must satisfy IRS nondiscrimination testing referred to as the Actual Contribution Percentage Test (ACP test).
A 401(k) Plan will fail the ACP test if the average contribution percentage of the HCEs exceeds the average contribution percentage of the NHCEs by a certain amount. If a 401(k) Plan fails the ACP test, excess contributions and allocable earnings will be distributed to HCEs. If no NHCEs make voluntary after-tax contributions to the 401(k) Plan for the year, the business owners and HCEs will not be able to take advantage of the “mega” portion of the backdoor Roth. They will only be able to defer up to $23,000 (for 2024) on a Roth basis.
Additionally, by allowing for voluntary after-tax contributions, the 401(k) plan runs the risk of failing top-heavy testing (which is a subject for another post). If a 401(k) plan fails top-heavy testing, the company must make minimum contributions on behalf of non-key employees.
If that all sounds like a headache…
If all the above sounds like a headache to deal with, you are correct and that is why we do not recommend pursuing a mega backdoor Roth strategy if a business has non-highly compensated employees.
However, solo 401(k)s and owner-only plans are great candidates to implement a mega backdoor Roth strategy. Those plans are not subject to the ACP test, because their participation is limited to business owners.
In conclusion,
The mega backdoor Roth 401(k) offers high-income earners a valuable opportunity to accumulate wealth in a tax-efficient manner. However, there are nuances to be aware of, particularly if a business has employees.
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].