Mega-backdoor Roth

🇺🇸

It is possible to fund a Roth account far in excess of normal contribution limits  through a strategy known informally as the mega-backdoor Roth. This process is available only through select employer plans, and the rules for these plans may vary considerably from one company to another. As shown in the figure below, the strategy involves two steps:


 * 1) Contributing to an after-tax 401(k) account, and
 * 2) Rolling the funds over to either a Roth IRA, or to a Roth sub-account within the plan.

The net effect of the above is equivalent to contributing to a Roth account, but there are no income limits for either of the two steps, unlike for Roth IRA contributions. The biggest advantage of this strategy stems from the fact that the after-tax 401(k) account has different rules from traditional and Roth 401(k) accounts: it is subject to much higher contribution limits (up to $58,000 in 2021, per IRC 415(c)), leading to the "mega-backdoor" moniker.

Note that "mega-backdoor Roth" is an informal term; neither the IRS nor your company will officially recognize it, and tax preparers may not be familiar with it either. The term is just a colloquial phrase that investors use. So if you come across someone who has never heard of it, just use the terms "after-tax 401(k) contribution" (step 1), and "Roth conversion" (step 2) instead, because that's what is really happening. After-tax 401(k) contributions are different from, and should not be confused with, Roth 401(k) contributions.

Also note that there is a process called backdoor Roth that is completely different from the mega-backdoor Roth. They are independent of each other, and can both be performed in the same year.

The discussion below refers to generic IRS rules; consult your own company's documentation for specifics.

Advantages

 * For those whose plans allow it, this strategy allows for large contributions to Roth accounts (theoretically up to $58,000, but more typically $38,500 minus any employer match), which are in addition to direct contribution limits to a Roth IRA, and to a 401(k) through elective salary deferrals. Tax-free growth on this money adds up to a large tax savings over an investor's lifetime.
 * If funds are rolled into a Roth IRA through in-service distributions, or into a Roth 401k using an in-plan Roth rollover, soon after contribution, gains (and tax on them) will be minimal. Further growth in either Roth account is tax-free (subject to the usual Roth restrictions).
 * Roth 401(k) conversions offer protection from creditors under ERISA.
 * Roth IRA conversions have the advantage of flexible withdrawals: see the Withdrawals section below for details.

Potential disadvantages

 * Additional paperwork: You may receive two 1099-R's every year, one for the rollover and one for the gains. As many accountants aren't aware of the documentation requirements, this increases the chance for error.
 * If you die with funds waiting for rollover, the inheritor is left with a non-deductible IRA with more complicated paperwork.
 * If you incur losses before rollover, "basis" could be lost if you don't leave a few pennies in the account. Check with your plan to see how it handles this situation.
 * If the company fails nondiscrimination tests, restrictions on contributions (e.g. as a percent-of-pay limit) or a return of contributions may result. See Highly compensated employee.
 * Saving such a large amount of money inside a retirement account may be too big a strain on some investors's budgets. While a Roth account provides great tax savings, asset protection, and estate planning benefits, investors should consider this strategy as part of their overall financial plan, fitting any contributions within their budget, and considering both immediate and future financial goals. Investors not able to comfortably make a full mega-backdoor Roth contribution should consider a partial contribution instead, and non-mega-backdoor Roth contributions should be made first.

Determining if your plan supports the mega-backdoor Roth
The mega-backdoor Roth strategy is not supported by all 401(k) plans. The plan must offer both of the following features:
 * 1) After-tax contributions to the 401(k), and
 * 2) Roth conversions of after-tax contributions, either as an in-plan conversion or as an in-service distribution, as described below.

Note that "mega-backdoor Roth" is an unofficial term and unlikely to be recognized by your company; the bolded phrases above are what you should check for. Your 401(k) plan documentation, often referred to as a Summary Plan Description, contains the details for after-tax withdrawals or conversions and whether or not they're allowed. Specifically, they need to be allowed without a "triggering event". Triggering events include job loss, retirement, or death, and are typical for many types of contracts.

The rules regarding Roth conversions of after-tax 401(k) contributions vary greatly between employer plans. Some allow for in-plan conversions into a Roth 401(k) account, while other plans allow a rollover into a Roth IRA account, which is referred to as an in-service distribution. If both options are offered, which one may be preferred is a personal choice, but below is some rationale for each approach.


 * {| class="wikitable" style="max-width: 90%;"}

! style="width: 45%; text-align: center" | Roth 401(k) conversion ! style="width: 55%; text-align: center" | Roth IRA conversion
 * style="vertical-align: top;" |
 * Can minimize taxable earnings if an automatic conversion plan is offered.
 * May be easier to set up.
 * Offers a greater variety of investment options.
 * Flexibility of withdrawals, since Roth IRA contributions (but not earnings) can be withdrawn without penalty.
 * }
 * Flexibility of withdrawals, since Roth IRA contributions (but not earnings) can be withdrawn without penalty.
 * }
 * }

See also: Comparison between IRAs and employer plans.

Be sure to check for rules or restrictions that may surround withdrawals. Some potential examples include suspension of after-tax contributions, or matching contributions, for a specified timeframe after receiving the distribution; or requiring you contact Human Resources to resume making after-tax contributions to your plan.

Earnings on after-tax contributions
Earnings associated with after-tax contributions (i.e., earnings that occur in between step 1 and step 2) are pretax amounts. Distribution of these earnings (in step 2) is therefore taxable as ordinary income. Therefore, to avoid taxes, it makes sense to perform the two steps in quick sequence. To facilitate this, some plans may also provide for automatic in-plan Roth conversions, which can be scheduled to occur immediately after the after-tax 401(k) contribution. Another option is to invest the after-tax contributions in a stable value fund or a money market fund, to minimize taxable earnings in the short period before performing step 2.

Alternatively, any earnings may be rolled over into a traditional IRA. Note, however, that this may cause pro-rata issues if the backdoor Roth is also being performed in the same year. In this case it should be possible to roll the earnings back into the 401(k) pre-tax sub account; this rollover would need to complete before December 31st. But, considering that the earnings may be small, it might make more sense to do a direct rollover of the entire amount to your Roth IRA and pay taxes on the earnings.

If desired, the plan provider should provide the option to distribute the contributions and earnings separately (one check for earnings, one check for contributions). Each distribution can then be rolled over into a separate, appropriate account.

Some plan providers may not offer this choice (one check for both earnings and contributions). If this is the case, request a single check payable to yourself. The plan must withhold 20% of the earnings (the pre tax portion of the check), so your net check is a little less than the distribution. Then, do a 60 day rollover of the gross pretax amount (the earnings) to your traditional IRA. Do this first. Once complete, then roll the after tax amount (making up the withheld amount from your other funds) into your Roth IRA. There is no tax on the distribution. Report it as a rollover on Form 1040 lines 5a and 5b just like you would a direct rollover. Remember to claim credit for the withholding that will show on the 1099-R.

Withdrawals
The rules for withdrawals depend on how the mega-backdoor Roth strategy was executed: via a Roth IRA, or a Roth 401(k) conversion. The following discussion pertains only to Roth IRA conversions; for Roth 401(k) withdrawal rules, consult your company's documentation.

Roth IRAs offer flexibility in withdrawals: direct contributions (but not earnings) can be withdrawn at any time without penalty. This is also true for amounts converted using the mega-backdoor Roth strategy, but there may be a penalty on any earnings that occurred before conversion. If the earnings were small, the penalty is also small; after 5 tax years, the penalty becomes zero. This is explained below using an example.

Example
Consider a 30-year-old investor who has made $6000 in direct contributions to her Roth IRA. She now decides to employ the mega-backdoor Roth strategy: she contributes $10,000 to her after-tax 401(k) account (step 1), and then rolls it over to her Roth IRA (step 2). Suppose there were $100 in earnings accrued in between steps 1 and 2. The net balance in the Roth IRA is now $16,100.

If the investor now wishes to withdraw money from her Roth IRA, she must do so in this order:


 * First, the $6,000 in direct contributions.
 * Next, the $100 in pre-conversion earnings (with an associated 10% penalty).
 * Then the remaining $10,000.

If she were to withdraw the entire balance, she would pay a $10 penalty to withdraw $16,100. If there had been no earnings pre-conversion, there would be no penalty (10% of $0 = $0).

The penalty on pre-conversion earnings can be avoided if the withdrawal takes place after 5 tax years, i.e., after January 1 of the 5th year following the conversion. This is known as the 5-year rule for Roth conversions.

A more complex example
The investor repeats the mega-backdoor Roth process next year: this time, she contributes $20,000, and accrues $200 in between steps 1 and 2. Also suppose the money that was already inside the Roth IRA grew by $1000. If she now wants to draw money from the account, it must be in this order:


 * First, the $6,000 in direct contributions.
 * Then the first conversion, in this order:
 * The $100 in pre-conversion earnings (with an associated 10% penalty).
 * The remaining $10,000.
 * Next, the second conversion:
 * The $200 in pre-conversion earnings (with an associated 10% penalty).
 * The remaining $20,000.
 * Finally, the $1000 in earnings that occurred inside the Roth IRA (with an associated 10% penalty, as well as taxes).

These examples show the importance of keeping long-term records of how money gets into the Roth IRA. Withdrawals must happen in the order described above, with conversions ordered first-in, first-out. And each conversion has its own 5-year clock, after which the penalty on the (small) pre-conversion earnings becomes zero.

For further details such as distributions after age 59.5, exceptions to penalties, etc., see the Roth IRA article.

The backdoor and mega-backdoor Roths
The mega-backdoor Roth should not be confused with the backdoor Roth, a similarly titled but entirely different technique, which allows you to fund a Roth IRA in excess of income-based contribution limits. As the name implies, the mega-backdoor Roth (usually) allows a larger contribution than the backdoor Roth.

However, this doesn't mean you should do only one or the other. As the following table shows, they are independent strategies with separate limits, which can both be executed in the same year. They both involve two steps: contribution and conversion, but use a completely different set of accounts. Be sure to thoroughly read the corresponding articles and IRS documentation before attempting either, as mistakes may be time-consuming and costly to rectify.

Note that there is one special situation in which the two processes can interfere, described in the previous section, that occurs when rolling over after-tax earnings to an IRA. This can be resolved using any of the methods described in the backdoor Roth article, such as rolling the IRA earnings back over to a 401(k).

Mega-backdoor Roth with a Solo 401k
While the previous sections apply generally to employer plans, there are special considerations for employees who are their own employer (i.e., are paid directly by customers or on a Form 1099, instead of on a W-2). Self-employed individuals have access to an Individual or Solo 401k, which they both administer and contribute to. This has a number of implications for the mega-backdoor Roth process.

Without a mega-backdoor Roth, contribution limits to a Solo 401k are:
 * Up to the Section 402(g) elective deferral limit ($19,500 in 2021) from wages paid through payroll, and can be traditional or Roth as the plan allows
 * Up to 25% of wages paid through payroll as employer contributions, and these can only be traditional
 * Up to the Section 415(c) limit ($58,000 in 2021) for total of all employee and employer contributions

Therefore, a self-employed investor can contribute the maximum to their Solo 401k with wages of at least $154,000 (=[$58,000 - $19,500] / 25%) if making an elective deferral, or $232,000 (=$58,000 / 25%) if not (e.g., making the elective deferral at another employer to get a match).

When adding a mega-backdoor Roth strategy, the total of elective deferrals and after-tax contributions cannot be greater than wages, and the total of all elective deferrals, after-tax contributions, and employer contributions cannot be greater than the Section 415(c) limit. While the mega-backdoor Roth does not raise the general amount that can be contributed to a Solo 401k, it does have two consequences that could be beneficial to certain investors.

First, it allows maximum contribution with much lower wages, and by extension much less business income. If contributing entirely with elective deferral and after-tax contributions, wages of just $58,000 are needed, with the caveat that after-tax contributions cannot be tax-deferred like employer contributions. This can be an advantage for investors whose business doesn’t earn enough to pay the wages needed to contribute the maximum otherwise, and/or investors who prefer to pay lower wages to themselves due to the payroll tax savings.

Second, it allows a potentially larger Section 199A deduction, both through lower wages, and also because employer contributions are deductible against Qualified Business Income (QBI) while employee after-tax contributions are not. This advantage only applies to self-employed investors who are able to take advantage of a Section 199A deduction; owners of a Specified Service Trade or Business (SSTB) whose income is above the phase-out limit will get no benefit through this mechanism, although lower wages will still provide a payroll tax savings. Investors who are inside the SSTB phase-out range will likely see very high marginal tax rates, and should likely maximize deductible employer contributions before pursuing any mega-backdoor Roth strategy, to lower taxable income.

Salary
The IRS requires business owners to pay themselves a “reasonable” salary with wages, placing an additional constraint on Solo 401k contributions. Readers unsure of what constitutes “reasonable” compensation for their particular situation should consult a tax professional. The IRS is aware of the tax savings that can be realized through lower salaries, particularly after the passage of the Tax Cuts and Jobs Act and the Section 199A deduction. IRS guidance states that business revenue generated by a shareholder's personal services should be classified as wages. In addition to the risks of taxes and penalties, lowering one's salary can have other negative impacts, such as reducing future Social Security benefits, and possible benefits through your state's unemployment program.

Mega-backdoor Roth capable Solo 401k plans
None of the free Solo 401k plans from the major brokerages (E*Trade, Fidelity, Vanguard, etc.) allow after-tax contributions, and by extension the mega-backdoor Roth. Performing a mega-backdoor Roth in a Solo 401(k) requires the administration by a qualified Third Party Administrator (TPA), who can ensure all legal and paperwork requirements are met. The administrator's fees should be weighed against any potential tax savings of a mega-backdoor Roth.

Advantages with a Solo 401k plan
Potential advantages include:
 * Investors can contribute the maximum to a Solo 401k with a much lower salary and business income
 * Investors can get a larger Section 199A deduction
 * Investors who already desire Roth contributions may prefer mega-backdoor Roth contributions to making employer contributions and then trying to roll those over into a Roth account

Disadvantages with a Solo 401k plan
Potential disadvantages include:
 * Mega-backdoor Roth-capable Solo 401k plans are more complex and have setup and ongoing fees
 * Mega-backdoor Roth contributions can only be Roth, so investors who have a strong desire for traditional contributions (e.g., those in the SSTB phase-out range) may see adverse tax impacts
 * There is additional complexity to performing this multi-step maneuver, and more opportunities for mistakes

Example
A married self-employed investor earns $250,000 per year in their non-SSTB S-corporation, net business expenses but before wages and payroll tax. Without a mega-backdoor Roth strategy, and assuming the investor makes an elective deferral and sets their wages at $154,000 to maximize Solo 401k contributions, their Qualified Business Income (QBI) and Section 199A deduction would be calculated as follows:

Taxable income would be calculated as follows:

If this investor instead decided to adopt a mega-backdoor Roth strategy using a Solo 401k with a $500 fee, set their salary to $100,000 (the minimum their tax advisor recommends while still being reasonable), no employer contributions and the net as after-tax contributions, QBI would be calculated as follows:

Taxable income would then be calculated as follows:

Taxable income is predictably higher due to the Roth contributions, but the complete tax picture is more complex. Assuming this investor is in the 24% tax bracket, net impacts to each type of tax are as follows:

The effective marginal tax rates for this strategy tell an interesting story. The marginal tax rate for the $38,500 mega-backdoor Roth contribution can be calculated in several ways:

Looking only at income tax and treating the Solo 401k fee as a tax-like cost, this investor can contribute $38,500 to Roth accounts at a marginal tax rate of just 15.23%, despite being in the 24% bracket. Marginal tax rate calculations do not typically include payroll tax, because there is usually no difference; normal retirement contributions are not payroll tax-deductible. However, in this case, there is a change in payroll taxes by adopting the mega-backdoor Roth strategy. Also considering the savings in Medicare tax, which does not provide any direct benefit to the taxpayer, the effective rate drops to around 11%.

If Social Security tax is included as well, the rate drops below zero, meaning that the total taxes and fees paid by this investor actually drops despite contributing to Roth accounts rather than tax-deferred. This may not be a fair comparison, because higher Social Security taxes provide an enhanced benefit in retirement. However, the effect is smaller for higher earners, because the benefit calculation is highly progressive.

Note that the payroll tax savings can be realized without the mega-backdoor Roth strategy simply by lowering the salary to $100,000 with a standard Solo 401(k). However, this would lower maximum contributions to $44,500, $19,500 from elective deferrals and $25,000 from the business, the latter of which must be tax-deferred.