Mega-backdoor Roth

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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. 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), 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

 * Subject to much higher contribution limits than a Roth IRA or Roth 401(k) account (up to $57,000 in 2020, $58,000 in 2021).
 * If funds are rolled into a Roth IRA, or a Roth account within the 401k using an in-plan Roth rollover soon after contribution, gains (and tax on them) will be minimal. Further growth in the Roth IRA is tax free (subject to the usual Roth IRA restrictions).
 * Some 401(k)s allow for in-service distributions, allowing employees to roll over funds during employment without a triggering event.
 * Protection from creditors under ERISA.

Potential disadvantages

 * Death, for monies waiting for rollover, the inheritor is left with a non-deductible IRA with very complicated paperwork.
 * 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.
 * 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.
 * Company fails nondiscrimination tests, resulting in a return of contributions. See Highly compensated employee.

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, if they are 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.

The in-plan conversion to a Roth 401(k) may be preferred since it can minimize taxable earnings if an automatic conversion plan is offered; it may also be easier to set up.

Alternatively, a Roth IRA conversion may be preferred due to the greater variety of investment options it offers, as well as flexibility of withdrawals, since Roth IRA contributions (but not earnings) can be withdrawn without penalty.

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 are pretax amounts. Distribution of these earnings is therefore taxable as ordinary income. Therefore 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, 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. Consider that the earnings may be so small that it makes 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.

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 that also allows you to fund a Roth account in excess of income-based contribution limits. As can be guessed by the name, the mega-backdoor Roth allows you to contribute more than the backdoor Roth (up to $58,000 vs. $6,000, per 2021 IRS limits ).

However, this doesn't mean you should do only one or the other. As the following table shows, they are independent strategies that can 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 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 (ie. 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 (eg. 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 minus the employee portion of payroll taxes, 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 ~$63,000 (= $58,000 / [1 – 7.65%]) 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.

Note that 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 should consult a tax professional.

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. Employee Fiduciary is one such TPA, and their Solo 401k administration price starts at a $250 setup fee and, and $500/year plus 0.08% of plan assets for ongoing administration. These fees should be weighed against any 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 (eg. 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.