What is the Mega Backdoor Roth?

A Mega Backdoor Roth is an enhanced version of the traditional Backdoor Roth IRA. The Mega Backdoor Roth involves converting additional after-tax contributions made to a 401(k) to either a Roth 401(k) within your 401(k) account or to your Roth IRA. This tactic enables an individual to contribute more to Roth than current IRA and/or 401(k) limits indirectly, and if converted to a Roth IRA, bypass Roth IRA income limitations.

Understanding How the Mega Backdoor Roth IRA works

To understand the Mega Backdoor Roth IRA, let's start with a brief overview of its predecessor, the Backdoor Roth IRA. In traditional IRAs, there can be contribution income limits for Traditional (or pre-tax) IRAs, and there are income restrictions for Roth IRAs. These limits vary for each type of IRA. In a Traditional IRA, if your spouse is covered by a retirement plan at work, exceeding the income limits means you lose the pre-tax deduction. In a Roth IRA, exceeding the income limits renders you ineligible to contribute, and you may need to refund your contributions during tax filing. However, there's a clever loophole: converting after-tax assets from a Traditional IRA to a Roth IRA is allowed, thus creating the Backdoor Roth IRA. This strategy lets you contribute indirectly to a Roth IRA without violating income limits.

The Mega Backdoor Roth takes this concept further, leveraging differences in contribution limits between IRAs and 401(k)s. In 2023, the contribution limit for IRAs is $6,500, while for 401(k)s, it's $22,500. However, there's an overlooked limit in 401(k)s: the total contribution limit, including both employee and employer contributions, is $66,000. This substantial limit is the key to unlocking the Mega Backdoor Roth.

Understanding After-Tax Contributions in a 401(k):

In a 401(k), there are three types of contributions: traditional pre-tax, Roth, and after-tax contributions. The after-tax contribution type treats your contributions as after-tax, just like Roth, but taxes investment gains as traditional pre-tax contributions. That is, any investment gains in an after-tax “bucket” will be taxed as regular income upon a qualified withdrawal when used in retirement. So, this after-tax money type has the cons of both the traditional and Roth money types without the pros of either. Which explains why this money type is seldom used and you may not have heard of it. There is, however, one distinct advantage of the after-tax money type and that is, the deferral limit is not $22,500 (like Roth and traditional). Instead, the after-tax deferral is subject to the total contribution limit of $66,000. You will want to consider any employer matching you are receiving as that is included in reaching the $66,000 maximum.

How Does the Mega Backdoor Roth Work?

Now that we've covered the mechanics, let's assemble the pieces for the Mega Backdoor Roth. If a participant contributes to the after-tax money type in the 401(k), they will then want to convert that money to the Roth bucket. By doing this, they have backdoored their way into Roth IRA. It’s called the Mega Backdoor Roth because unlike IRAs, the contribution limit to the after-tax 401(k) is $66,000. Therefore, instead of a backdoor Roth IRA, where the limit is $6,500, the 401(k) offers the opportunity for a participant to effectively contribute $66,000 to their Roth 401(k). Hence the term, Mega Backdoor Roth. It's essentially a supersized version of the Backdoor Roth IRA within your 401(k) plan.

Important Considerations of a Mega Backdoor Roth:

To make the Mega Backdoor Roth work, your plan needs to include the after-tax contribution type and allow either in-plan Roth conversions or in-service withdrawals. Either of these features would be required to allow a participant to immediately convert their after-tax contributions to Roth, either within the 401(k) or to a Roth IRA. It is important to note the timing of these conversions matters and can have tax implications. Any after-tax money with associated investment gains will be subject to taxation when converted to Roth. Some Plans that allow for this offer an immediate conversion to Roth to avoid this scenario.

Who Benefits from the Mega Backdoor Roth?

In most cases, the Mega Backdoor Roth is most attractive to employees that earn enough income to comfortably contribute more than $22,500 per year. For context, if you earn $150,000 annually and can put away 15% of your income that is $22,500. Individuals earning over $150,000 are considered Highly Compensated Employees in 401(k) plans and this implications plan testing as you’ll see in the next section.

Realistically, a participant wouldn't contribute the full $66,000 to the after-tax option. The first $22,500 would typically go to either the traditional pre-tax or Roth buckets. This means that, at most, $43,500 would be converted.

Moreover, keep in mind that the $66,000 limit combines both employee and employer contributions. If your plan offers a match or non-elective contribution, this further reduces the participant's after-tax contribution capacity. For example, if a participant earns $200,000 in income and the company matches 4%, the participant could contribute $22,500 and the company would match $8,000 for a total of $30,500 towards the $66,000 limit. This participant would then be able to contribute $35,500 to the after-tax “bucket”.

Why Isn't the Mega Backdoor Roth Available in Most 401(k) Plans?

401(k) plans are subject to IRS plan tests. These tests are designed to help ensure all participating employees can benefit fairly in a company’s 401(k) plan and not just the high earners. After-tax contributions are subject to the Actual Contribution Percentage (ACP) test. This risk of failing ACP testing is very high and is why the Mega Backdoor Roth isn't available in most plans. An employer would need a number of Non-Highly Compensated Employees (NHCE) to also contribute more than $22,500 after-tax to pass ACP testing, and that is understandably difficult.

What is the Actual Contribution Percentage (ACP) test?

The ACP test, or Actual Contribution Percentage test, focuses on contributions, including employer matching and after-tax contributions, to determine if the plan is favoring HCEs – (those earning $150,000+ annually) over NHCEs. Like the ADP test, the ACP test aims to prevent discrimination in plan contributions. It calculates the average contribution percentages for both groups and compares them. If the contribution gap surpasses specified thresholds, the plan may fail the ACP test, potentially triggering the need for refunds or adjustments to maintain fairness and compliance within the plan.

Final Thoughts:

The Mega Backdoor Roth could be a powerful tool for those who can utilize it effectively. Unfortunately, few companies have the right mix of HCEs and Non-HCEs making after-tax contributions for the plan to pass testing. If your company does have the specific demographics and contributions to meet testing parameters, you will want to ensure your plan documents and plan provider will support it.

If you have more questions, feel free to give us a call at (800) 431-7934.

Key Takeaways:

The Mega Backdoor Roth is an advanced version of the traditional Backdoor Roth IRA, allowing individuals to convert after-tax contributions from a 401(k) to a Roth 401(k) or Roth IRA, surpassing regular contribution limits and avoiding income restrictions.

The Mega Backdoor Roth leverages differences in contribution limits between IRAs and 401(k)s, with a substantial $66,000 limit for 401(k)s in 2023, making it an attractive option for those with higher incomes.

To make the Mega Backdoor Roth work, your plan must include after-tax contributions and allow in-plan Roth conversions or in-service withdrawals. The timing of conversions is crucial to minimize tax implications.

The Mega Backdoor Roth is most beneficial for high-income earners who can contribute more than $22,500 annually to their 401(k).

The Mega Backdoor Roth isn't available in most 401(k) plans due to the risk of failing the Actual Contribution Percentage (ACP) test, which aims to prevent discrimination in contributions between Highly Compensated Employees and Non-Highly Compensated Employees.

**Please note that catch-up contributions for individuals aged 50 and over are additional and not included in the discussed contribution limits. *

*This is not meant to be tax advice. ShareBuilder 401k does not offer tax or legal advice. Consult with your tax or legal advisor before engaging in specific strategies. *