As recently as this week, there are tax proposals in Congress which, if passed, would potentially impact the power of the mega backdoor Roth IRA. Of course, no one knows if these proposals will become law and whether or not Roth IRA provisions will be included in any final legislation.

Bottom Line: If you are interested in a mega backdoor Roth IRA after reading this article, be sure to contact us so we can guide you as rules change for 2021 and beyond.

HOW TO CONTRIBUTE UP TO $38,500 TO A TAX-FAVORED ROTH IRA, EVEN IF YOU EXCEED INCOME LIMITS

A mega backdoor Roth is a special type of 401(k) rollover strategy used by physicians with high incomes to deposit funds into a Roth individual retirement account (IRA). Pursuing this strategy makes sense only if you have already maxed out your annual 401(k) and IRA contributions and still have extra savings that you would like to get into a Roth IRA. While this tool can be a powerful one, it comes with several rules, which we outline below.

You may be able to make a mega backdoor Roth contribution if you:

  • Have a 401(k) plan at work
  • Your 401(k) plan allows after-tax contributions
  • Your 401(k) plan permits in-service withdrawals or rollovers

There are several ways to fund a Roth IRA, and each strategy has different rules and restrictions. A mega backdoor Roth allows you to contribute significantly more funds to a Roth IRA than other Roth IRA funding strategies. Here are the various types of Roth IRAs, along with the funding methods and limits for each.

Roth IRA  

A Roth IRA is an attractive retirement account because growth and distributions are tax-free, and the account owner does not have to take the required minimum distributions in retirement. Unlike a traditional IRA, the money contributed to a Roth IRA has already been taxed. However, a Roth IRA has income limits that prohibit high earners from contributing directly to an account and a relatively low contribution limit of $6,000 to $7,000 per year, depending on your age.

Backdoor Roth

A backdoor Roth is a way for high-income individuals to bypass the ordinary income limits for a Roth. An individual can open a traditional IRA, immediately convert it into a Roth IRA, and then pay any taxes owed. However, you can only contribute $6,000 a year to an IRA ($7,000 if you are over 50). We have written about this strategy in more detail: Backdoor Roth IRA.

Mega Backdoor Roth 

Some people who have an employer-based 401(k) plan  that allows after-tax contributions and in-service distributions have the option to create a mega backdoor Roth. If you meet all the rules and requirements for this type of Roth IRA, you can save up to an additional $38,500 in 2021  by putting after-tax funds in the 401(k) and then rolling it over to the Roth IRA. However, not all 401(k) plans allow this option for additional retirement savings.

Important Considerations for Mega Backdoor Roth IRAs

While mega backdoor Roths can be extremely atrractive for high income earners looking for long-term tax diversification, these tools do come with a variety of rules to satisfy.  While recent IRS guidance has sparked high levels of interest, one still needs “to do it right.”  Here are a few of the leading factors to consider:

After-tax Contributions

After-tax contributions are not elective deferrals and therefore are not subject to the annual Section 402(g) maximum deferral limit ($19,500 for 2021). However, they are subject to the annual Section 415 limit ($58,000 for 2021; $64,500 for individuals age 50 or older eligible to make catch-up contributions of $6,500).

Conversion via IRR (In-Plan Roth Rollover)

A plan that permits both after-tax contributions and designated Roth contributions could be designed to also permit in-plan Roth rollovers (IRRs). This would allow participants to convert after-tax contributions into designated Roth accounts. Earnings converted with the after-tax amounts would be taxed in the year of the IRR. However, future earnings in the Roth account would not be taxed when distributed, provided they satisfy the qualified distribution requirements (generally, that the participant must be age 59½ or older and the designated Roth contributions must satisfy the five-year rule).

Potential Issues

Including after-tax contributions in a plan can pose testing and administrative issues. “One-participant” plans (plans covering a business owner with no employees or a business owner plus spouse) face the fewest issues. Plans with non-highly compensated employees (NHCEs) face the greatest number of challenges because nondiscrimination testing must be performed on after-tax contributions.

ACP Nondiscrimination Testing

Actual contribution percentage (ACP) testing is generally required for plans with employer matching contributions. After-tax contributions are also subject to annual ACP nondiscrimination testing. If a plan has both after-tax and matching contributions, they are tested together in one ACP test. Note that safe harbor 401(k) plans are required to perform an ACP test for any after-tax contributions that are made; safe harbor matching contributions are exempt from testing.

After-tax contributions are typically made by highly compensated employees (HCEs) who wish to contribute more than the annual Section 402(g) deferral limit allows. Since plans with HCEs often have nondiscrimination testing issues, such plans may face even greater testing issues if they allow after-tax contributions. One way to minimize the impact of after-tax contributions on nondiscrimination testing is to administratively limit the dollar amount of after-tax contributions individuals can make for each plan year.

415 Limitations

IRC Section 415 rules limit the total amount that can be contributed to a participant’s account on an annual basis. Participants who make after-tax contributions need to be aware of that limit. Otherwise, they might run into a situation where an employer contribution causes them to exceed the annual Section 415 limit. If this limit is exceeded, the participant must receive a corrective distribution of the excess amount. After-tax contributions are generally the first type of contribution to be refunded.

Conclusion

A mega backdoor Roth IRA can maximize tax savings for physicians who have more income available for savings, and who are first maximizing their savings in other avenues, including 401(k), IRA, HSA, and 529 plans. Because the mega backdoor Roth is a complicated strategy  with many moving parts and the potential for unexpected tax bills, you should consult with a financial or tax advisor before implementing this retirement savings tool.

Be sure to read the other articles featured in our September 2021 newsletter: