Helping employer setup after-tax 401K contributions (mega backdoor): How do we allow employees to convert to Roth?

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Topic Author
nerdymarketer
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Joined: Mon Sep 02, 2013 8:18 pm

Helping employer setup after-tax 401K contributions (mega backdoor): How do we allow employees to convert to Roth?

Post by nerdymarketer »

A couple of weeks ago, I asked what it would cost to have our 401K plan amended to support after-tax, non-deductible contributions (aka mega-backdoor). For context, this is a software startup with 300+ people, and the actual administration of the 401K plan is handled by a third-party company. Surprisingly, it sounds like it'll only cost the company $200 to amend the plan document to support these contributions, and so our CFO / head of HR are both open to the idea.

They asked me to meet with them and the 401K administrator rep later this week to discuss details. So I have a few questions regarding the best way to allow employees to convert these after-tax contributions to Roth.

I know the standard way is for the employee to wait until they leave the company, and then rollover to a Roth IRA. But after a few years when an employee has shoveled a couple of hundred grand into this account, they become incentivized to leave the company so that further gains on these after-tax contributions are protected. We obviously don't want this.

How can we make it so employees can convert these contributions to Roth without leaving the company?
Ideally, with minimal cost increase to our company from the 401K administrator.

The two options I've seen are:
1) allow in-plan rollovers from after-tax bucket to the Roth bucket within the 401K. This was mentioned in a post on thefinancebuff, but I haven't seen this mentioned elsewhere, so I'm not sure if it's legal? Supporting this appears very straightforward from an administrative perspective.

2) Allow in-service distributions from the 401K to the employees Roth IRA. I'm worried about the increased admin cost. I assume we would want to limit these to once or twice a year. And allowing this would decrease the assets under management in the 401K plan, so how would that affect admin fees?

At the end of the day, is it actually complicated for the administrator to deal with these conversions/distributions? Does the IRS require distributions to be pro-rata, or can an employee specify a $ amount and bucket for a distribution? IF the distribution is required to be pro-rata, does the plan admin have to track that or can they just warn the employee and let them handle it?

Anything else I'm forgetting that I should ask to be structured into this switch to mega-backdoor?
Last edited by nerdymarketer on Wed Dec 13, 2017 1:36 am, edited 1 time in total.
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retiredjg
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Re: Helping employer setup after-tax 401K contributions (mega backdoor): How do we allow employees to convert to Roth?

Post by retiredjg »

There are two different things possible. They can allow one, the other, or both. I'm sure each one has a cost.

1) In plan Roth Rollover (IRR) - this would allow an employee to convert pre-tax money (the $18k a year) to Roth 401k. It would also allow the employee to roll/transfer an after-tax account (including the earnings) to Roth 401k.

2) In-service distribution of the after-tax account. Certain accounts (and not others) in a 401k are allowed to be transferred out while still working there. The mega back door is an in-service distribution of an after-tax account - it usually goes to Roth IRA but could go to both tIRA (the pre-tax earnings) and Roth IRA (the after-tax contributions).

I'm sure there is A LOT more to it than this. I'm just posting some info to get you started.
At the end of the day, is it actually complicated for the administrator to deal with these conversions/distributions?
It probably is not too complicated for someone who knows what they are doing. If someone in HR is doing it....they will need specific training and maybe a lot of help. Are you using a TPA (third party administrator) or is someone from HR taking care of it all?
Does the IRS require distributions to be pro-rata, or can an employee specify a $ amount and bucket for a distribution?
Both.
IF the distribution is required to be pro-rata, does the plan admin have to track that or can they just warn the employee and let them handle it?
I can't imagine that the employees would ever be given any control or say-so over this. It is all done by someone trained to do it right. You think of your 401k as one account but it is actually an account with several sub-accounts that are all accounted for separately. Adding this option is going to cost money on an ongoing basis so try to be understanding if it does not happen. On the other hand, if the owners of the company can benefit from it, you might have a chance.
Spirit Rider
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Re: Helping employer setup after-tax 401K contributions (mega backdoor): How do we allow employees to convert to Roth?

Post by Spirit Rider »

1) What you are referring to is an In-plan Roth Rollover (IRR). It is a real thing and is most definitely supported in the Internal Revenue Code and in IRS regulations. The rollover itself is easier from an administrative point of view, because the assets stay in the plan, but the IRS 1099-R is similar to option 2).

2) Most new plans that add after-tax contributions also allow in-service rollovers. There would be additional administrative costs for the rollover(s), but the IRS reporting would be similar to option 1). Anecdotal information indicates that while some plans limit the rollover(s) to once/year, many allow them more often such as once/quarter. Once/year makes them much less valuable, because you will accumulate more taxable earnings. I don't understand how adding after-tax contributions and allowing in-service rollovers decreases the assets under management. It couldn't be any less than the current plan asset trends.

All distributions must come proportionally from after-tax contributions and their taxable earnings. Full distributions allow you to roll over the after-tax contributions to a Roth IRA and roll over the taxable earnings to a traditional IRA. The combined rollovers will be tax-free. If you want, you can make a single rollover of the after-tax earnings and taxable earnings to a Roth IRA. The taxable earnings will be taxable income. Partial rollovers have more complex treatment.
Topic Author
nerdymarketer
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Re: Helping employer setup after-tax 401K contributions (mega backdoor): How do we allow employees to convert to Roth?

Post by nerdymarketer »

Thank you both, that is very helpful.

The plan is administered by a third-party company, so we'll see what they say as far as costs for both options. Sounds like both options are about the same from an employer perspective. From an employee perspective, our current 401K has good low-cost index options, so again both options seem fine. Personally, I'd slightly prefer if they allow in-service rollovers as then if the 401K options ever go bad I have more control over where to invest that money, but it's only a slight preference as I think the risk of that is pretty low for the forseeable future.
Topic Author
nerdymarketer
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Re: Helping employer setup after-tax 401K contributions (mega backdoor): How do we allow employees to convert to Roth?

Post by nerdymarketer »

Wow.

So literally the costs to the company to add support for after-tax contributions, in-plan-roth-rollover, and in-service distributions are less than $1K to amend the plan document. There is no assets-under-management fee (I suspect this happens under-the-covers by the fund options in the plan giving a small kickback to the TPA). Each distribution costs the employee $75, the TPA rep has to doublecheck, but he didn't think the employee got charged a fee for in-plan Roth-rollover.

So it looks like all three things are going to be added to the plan.
Spirit Rider
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Re: Helping employer setup after-tax 401K contributions (mega backdoor): How do we allow employees to convert to Roth?

Post by Spirit Rider »

Congratulations. One person can make a difference.

One caveat, even if the 401k is a safe harbor plan, after-tax contributions are still subject to Actual Contribution Percentage (ACP) anti-discrimination testing. This could limit the after-tax contributions of HCEs to no more than 2% > than NHCEs.

Since you are amending the document, you might want to encourage the company to also match after-tax contributions if the employee chooses those. You might also want to strongly encourage NHCEs to really plan for their future and given how they can get large Roth IRA contributions, they really, really should up their contribution percentages.
Topic Author
nerdymarketer
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Re: Helping employer setup after-tax 401K contributions (mega backdoor): How do we allow employees to convert to Roth?

Post by nerdymarketer »

Yes, the TPA mentioned that limitation, which there is a decent likelihood the company will hit, but they said the worst case the company just gives back some of the contributions to the employees. The tricky part I hadn't realized was that after-tax contributions fit into a different bucket for means testing. I had assumed they were lumped in with the normal employee contributions, but apparently they are treated as completely separate buckets for means testing.

Additionally, most people are highly paid at the company so they suggested switching means testing to a different method. I don't remember the details, but I think it was to designate the top 20% or some number as HCE rather than a specific dollar cutoff. I will not be in the HCE category because when I started I negotiated a lower salary in exchange for more options, and supposedly the value of the options are not included in the compensation calculation for HCE.

Spirit rider if any of the above is factually incorrect, please let me know. This is what our TPA told us.

And yes, a few of us who care will do a major internal PR campaign to get contributions higher from other NCHEs as well.
Spirit Rider
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Re: Helping employer setup after-tax 401K contributions (mega backdoor): How do we allow employees to convert to Roth?

Post by Spirit Rider »

It sounds like your company's TPA is really on the ball with this one.

Yes, if you have a large percentage of HCEs, using the top 20% criteria for the testing instead of the fixed salary level (2017 = $120K) can allow those < the 20% level, but >= $120K to avoid having their after-tax contributions limited.

The thing with HCEs, if you can get them excited about this opportunity, because their wages are lower, it takes far less money to bump the contribution percentage.
Topic Author
nerdymarketer
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Re: Helping employer setup after-tax 401K contributions (mega backdoor): How do we allow employees to convert to Roth?

Post by nerdymarketer »

I want to followup here, as I'm slightly confused.

It turns out there was a miscommunication between the TPA and myself (and the other employees advocating for this) regarding the in-service rollovers allowed by our plan. We thought our plan already supported this, but it turns out that currently our plan only allows in-service distributions for employees who are older than 59.5.

When I asked about amending our plan to allow in-service rollovers from the 401K to IRAs, the TPA said that wasn't allowed. They said that if they allow in-service distributions of any kind for anyone below 59.5, they have to treat it like a full-blown distribution, meaning they are required to withhold taxes + a 10% penalty.

While their logic seems straightforward, I am 99% certain in-service rollovers from the employee's 401K to the employee's IRAs are allowed for the full amount without the TPA being required to withhold taxes/penalties of any kind.

What distinction am I missing here?

Is there an IRS ruling or webpage somewhere that I can show the TPA to convince them that it's legal to add this feature to our plan?
Spirit Rider
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Re: Helping employer setup after-tax 401K contributions (mega backdoor): How do we allow employees to convert to Roth?

Post by Spirit Rider »

I see we are both up late, or in my case my back woke me up after too much snow removal over the last few days.

The TPA is not correct.

While IRS regulations do prohibit in-service withdrawals/rollovers of employee deferrals and non-vested employer contributions prior to age 59 1/2.

401k plans can allow in-service withdrawals/rollovers of after-tax contributions and their associated earnings prior to age 59 1/2.

Withdrawals would be subject to 20% withholding and the earnings withdrawn would be subject to ordinary income tax and the 10% early withdrawal penalty.

However, direct rollovers would not be subject to withholding. A split rollover of the after-tax contributions to a Roth IRA and the after-tax earnings to a traditional IRA would have no tax liability. A single rollover to a Roth IRA would be subject to ordinary income tax only on the earnings. There would be no penalty.

This really surprises me that the TPA thinks this. This is easily available information. Although, you will excuse me if I go back to bed and pick this up in the morning if somebody else hasn't already provided some references.
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retiredjg
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Re: Helping employer setup after-tax 401K contributions (mega backdoor): How do we allow employees to convert to Roth?

Post by retiredjg »

It is possible your and your TPA administrator were talking apples and oranges. Or the TPA administrator was wrong. Or your plan does not use separate accounts (possible but most do these days).

It is correct that you cannot withdraw your elective deferrals without penalty prior to age 59.5 without an exception. But the mega back door is based on a non-hardship in-service withdrawal and that type of withdrawal is allowed for certain portions of your 401k if the 401k uses separate accounts for the different portions of your money.

If you do a search on non-hardship in-service withdrawal, you'll find many examples written by financial companies who are looking to get your 401k money to invest. Here are two examples.

http://www.titanfinancial.net/blog/how- ... r-employer

http://www.anthonycap.com/blog/service- ... plan-rules

I have also seen an IRS page verifying this, but am unable to find it right now.

Spirit Rider, I hope you were able to go back to sleep and get some rest!
Topic Author
nerdymarketer
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Joined: Mon Sep 02, 2013 8:18 pm

Re: Helping employer setup after-tax 401K contributions (mega backdoor): How do we allow employees to convert to Roth?

Post by nerdymarketer »

Thank you both, this is very helpful. I will contact the TPA and try to push this one across the finish line.

One followup question:

I see the IRS permits this non-hardship in-service rollover only for after-tax contributions, not for Roth contributions. Good explanation here: https://thefinancebuff.com/in-service-w ... rules.html

I have already executed an in-plan rollover from the after-tax bucket to the Roth status. Is this permitted to be rolled out of the plan even though it's since been converted to Roth status? Not sure if it is now treated as rollover Roth money or as a Roth contribution in the eyes of the IRS.

Even if this is permitted I'm not sure if the TPA keeps track of Roth rollovers separately from Roth contributions, that may cause difficulties.
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retiredjg
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Re: Helping employer setup after-tax 401K contributions (mega backdoor): How do we allow employees to convert to Roth?

Post by retiredjg »

I don't know, but I'd put my money on "no, you can't roll it out now".
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