Council Post: Backdoor Roth IRA Vs. ‘Mega Backdoor’ Solo 401(k)

Adam Bergman is the President of IRA Financial Group & IRA Financial Trust Company – a leading provider of self-directed retirement plans.

For high-income individuals, contributing funds to a Roth individual retirement account (IRA) is only possible through a solution known as the “backdoor” Roth IRA. This is because the IRA rules impose income limitations on Roth contributions, but no longer include those limitations on Roth IRA conversions.

Under the 401(k) plan rules, plans that include a Roth contribution option do not have any income limitations. Furthermore, solo 401(k) plans that allow for after-tax contributions can offer plan participants the ability to contribute well over $50,000 into a Roth. This is known as the “mega backdoor” Roth strategy. Let me explain.

Backdoor Roth IRA

For 2021, if one is single and earns more than $140,000 or is married and files jointly and earns more than $208,000, one is not permitted to contribute directly to a Roth IRA. However, since January 1, 2010, anyone with a pretax IRA can perform a conversion irrespective of income. The main reason behind this rule change was to increase tax revenues for the Treasury after the financial crisis, since Roth IRA conversions generate immediate taxation on the amount of the conversion. Hence, the creation of the “backdoor” Roth IRA conversion option.

How Does It Work?

Under this strategy, if you earn over the Roth IRA income limitations, you can contribute after-tax money to an IRA then immediately convert the funds to a Roth. After-tax contributions are not tax deductible, and the earnings are subject to tax. Obviously, this is not a popular contribution option other than for the purpose of a “backdoor” Roth. Once the after-tax contribution is made, you would immediately convert to a Roth as to not accrue earnings (and thus taxes).

There would be no tax on the conversion assuming you had no other pretax IRA funds and/or earnings. However, if you did, you would owe taxes on a pro rata basis. You are not allowed to pick and choose what you convert. All your IRA funds are considered, and the percentage of the conversion that is taxable is based on the amount of after-tax contributions versus any pretax contributions and earnings.

For example, if you have $10,000 in existing pretax IRA funds (including earnings) and contribute $5,000 in after-tax funds, you would pay taxes on 33% of the amount you convert.

The IRS is aware of the backdoor Roth IRA strategy, but has yet to impose any restrictions on its use.

Why Go Roth?

The Roth IRA can be a good retirement planning option for many people. While it does not offer an immediate tax deduction, all qualified distributions are tax free. Once you’re 59 1/2 and any Roth IRA plan has been open for at least five years, you never have to pay taxes or worry about capital gains on your withdrawals.

With income and capital gains taxes expected to increase for the wealthy in the near future, I believe the “mega backdoor” Roth IRA will likely become a key tax planning option for high-income earners. Further, Roth IRAs are not subject to any required minimum distributions. You never have to withdraw from the plan, and your IRA funds can continue to grow unimpeded.

‘Mega Backdoor’ Solo 401(k) Strategy

The “mega backdoor” solo 401(k) plan strategy is another option for Roth lovers. It allows a self-employed individual or small-business owner with no full-time employees to contribute after-tax funds to their plan and convert them to a Roth IRA. The strategy is generally only available for solo 401(k) plans since they are not subject to the top-heavy and other ERISA annual plan testing rules, which limits its availability for most traditional 401(k) or defined contribution plans.

After-tax 401(k) contributions are not treated as an employee deferral or employer profit-sharing contribution and can be made on a dollar-for-dollar basis. This gives one the power to supersize his or her retirement savings.

How Does It Work?

IRS Notice 2014-54 opened the door to the mega backdoor Roth 401(k) strategy, because it allowed for funds to be distributed from a 401(k) plan separately. Since after-tax contributions are not considered employee contributions or employer profit-sharing contributions, they are not subject to the plan triggering event rules and, as a result, can now be rolled into a Roth IRA.

Notice 2014-54 accelerated the popularity of the “mega backdoor” Roth strategy, because it allowed for after-tax solo 401(k) plan contributions to be rolled over to an after-tax IRA anytime and then converted to Roth IRA as an in-service plan withdrawal.

This allows one to contribute up to the annual contribution limit ($58,000 or $64,500 if age 50-plus in 2021) and then convert them to a Roth IRA. This is far more than the $6,000 or $7,000 you can contribute to an IRA this year.

Conclusion

For high-income earners wanting to make Roth IRA contributions, the backdoor Roth IRA strategy is a blessing. Whereas, the self-employed and small-business owners seeking to maximize Roth benefits can further benefit from the mega backdoor Roth solo 401(k) strategy.

Of course, you should be aware of any tax consequences, especially if you have existing IRA funds. For some, the immediate tax deduction from pretax contributions (if you qualify) might be more beneficial. As always, you should consult with a financial advisor when considering a backdoor Roth conversion.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

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