Maybe you’ve heard of a mega backdoor Roth 401k already. But, how do you navigate creating one as an employer with employees? Read below as we answer the question, what is a mega backdoor Roth 401k, and how to navigate it as an employer.
Saving for retirement is complicated, and the most common vehicle is a traditional 401(k). However, these plans result in the tax being deferred until retirement.
Because of this, some people prefer a Roth IRA or Roth 401(k), where you put the money in after paying tax on it. The distributions are then tax free. A tax advisor will generally tell you which option is going to work best.
There are also various ways to combine these options in an advantageous way. One of these is the mega backdoor Roth, which allows people with a good amount of savings to add a lot of money to their Roth IRA quickly.
What is a Mega Backdoor Roth 401k?
First of all, let’s talk quickly about what a backdoor Roth is. In order to have a Roth IRA, you have to have income below certain levels. In 2021, those levels are $140,000 for a single person or $208,000 for a couple filing jointly. If your income is above that limit, you can’t contribute to a Roth IRA.
What you can do is create a traditional IRA, put your money in it, then convert it to a Roth IRA. You will have to pay taxes on any gains the money made while in the IRA and repay the tax deduction. Ideally, what you do is put the money into the traditional IRA then immediately transfer it to the Roth.
So, a mega backdoor Roth is…doing this on a larger scale. It’s what you do when you have maxed out your contributes to both your 401(k) and your Roth IRA. First of all, your 401(k) plan has to allow after-tax contributions and let you move that money to a Roth IRA.
Not all employer plans do this, and employers should be ready to potentially be approached about this by their highest earners.
What you do is put in the maximum post-tax contribution, which is typically $58,000 in 2021. This is after your and your employer’s normal contributions. I.e., you put in all your after-tax savings and then immediately transfer those to the Roth IRA (or roll them into a Roth 401(k)) before they start making money.
You can also roll the contributions into a Roth IRA and the investment earnings into a traditional IRA. Yes, the IRS says this is okay. What the IRS doesn’t like is you rolling only after-tax amounts over. You have to also move across an equal amount of the pre-tax amount…although you can move it right back.
This is an option for you and your highly compensated employees, but there are some things to think about.
Who Benefits from a Mega Backdoor Roth 401k?
The mega backdoor Roth is an option for high earners who are able to save substantial amounts of money. Typically, you can move up to $38,500 into a Roth IRA this way. As it’s advantageous to max everything out first, you can see that this is the kind of thing available to C-suite executives and other high rollers.
You should also talk to your tax advisor first, as it may not be the most advantageous use of that money. It may, for example, be a poor strategy to do this when you have debt you could pay off. Most advisors suggest also maxing out your HSA if you have one, as well as your kid’s saving accounts. Bear in mind that you do not get an immediate tax benefit from doing this.
Basically, this is a great way to increase your retirement savings, but is not something you should do until you have taken care of your other key financial goals. Always talk to a tax advisor before deciding between this and other potential options such as taxable investment accounts or a Roth 401(k).
Is the Mega Backdoor Roth 401k Going Away?
Quite possibly. Congress sees this as a loophole that allows higher earning individuals to avoid paying taxes. It’s also seen as something that is done only by the ultra-wealthy.
Because of this, the House Ways and Means Committee is proposing prohibiting all employee after-tax contributions in qualified plans and converting after-tax IRA contributions to Roth. This would affect people below the $400,000 level below which Biden promised not to raise taxes, so it’s possible it won’t happen or will be offset by other changes to the tax code.
If you happen to have the kind of savings that would warrant using the mega backdoor Roth this year, you should absolutely consider doing so as it may be gone by the end of 2022.
It would also close the regular backdoor Roth IRA, denying people who have gone above the income level the ability to continue to contribute to a Roth IRA.
What Should Employers Think About?
If you have high earning employees, they might want to take advantage of the mega backdoor Roth. For them to do so, your plan has to be set up to allow both after-tax contributions and in-service withdrawals.
Also, it is actually beneficial for people using this loophole for you not to match contributions. However, you can’t treat people at different income levels differently when contributing to plans, so in order to help them out with this you would have to impact your lower-salaried employees as well. Thus, it’s something to be careful of; you can’t lower the CEOs contributions so they can use the mega backdoor without potentially getting into trouble with the IRS.
However, allowing after-tax contribution on its own can prevent the plan from passing the non-discrimination test. That is to say, it allows highly compensated employees to contribute more than the IRS limits, which is why many employees don’t allow this.
Allowing it just so that your highly compensated employees can take advantage of a loophole breaks not just the letter but likely also the spirit of this.
The mega backdoor Roth is something that some business owners can take advantage of, but you have to be very careful to avoid breaking IRS rules on retirement accounts.
For employers, it is a strategy that carries some IRS risk from allowing after-tax contributions or potentially treating highly compensated employees favorably. Finally, there is a very real chance this strategy is going away. Some people may want to take advantage of it this year ahead of potential legislation.