What is a Mega Backdoor Roth?
While many savvy investors know what a Backdoor Roth is, many are not familiar with what a Mega Backdoor Roth is. If you are a high-income earner with consistent cash flow to save for retirement, Mega Backdoor Roth feature can be a great option. Mega Backdoor Roth is essentially the “After-Tax” contributions in a 401(k) plan. After-Tax contributions are different from Roth 401(k) Deferrals.
How Much Can a Participant Contribute to a Mega Backdoor Roth?
After-Tax contributions allow a participant to put up to $37,500 ($57,000 – $19,500 = $37,500) in 2020 and $38,500 ($58,000 – $19,500 = $38,500) in 2021 into a Roth IRA, in addition to salary deferrals. Below is the equation to calculate how much a participant can contribute into his or her After-Tax portion in 2021:
$38,500 – Employer Match – Profit Sharing Contribution = After-Tax Contribution
How Does the Mega Backdoor Roth Work?
While it may sound simple, Mega Backdoor Roth process can get complicated. After-Tax Contributions and In-Service Distributions must be enabled in one’s 401(k) plan to do a Mega Backdoor Roth.
First, the participant would contribute up to the maximum allowed to the After-Tax bucket. Then, do an in-service withdrawal as a “rollover”. The After-Tax contributions can be rolled over to the Roth 401(k) account within the plan, or to one’s own Roth IRA account. There are tax implications to consider when choosing between your Roth 401(k) account and your Roth IRA account. When it comes to withdrawal rules, Roth IRA accounts receive more favorable tax treatment than Roth 401(k) accounts.
Things to Consider When Adding a Mega Backdoor Roth to Your 401(k) Plan
The most important factor to be aware is that Mega Backdoor Roth 401(k) plans will almost always fail Actual Contribution Percentage (ACP) Tests, if the plan has Non-Highly Compensated Employees (NHCE’s). Even offering NHCE’s a Non-Elective Contribution or a Safe-Harbor Match may not pass testing. Even if it does, the amount Highly-Compensated Employees (HCE’s) can contribute to the After-Tax (Mega Backdoor Roth) portion will be limited.
If you are a small business owner looking to create a 401(k) plan with a Mega Backdoor Roth feature, we highly recommend hiring a Third-Party Administrator (TPA) to administer the plan, as they can assist with contribution and deferral testing.
The bottom line is that 401(k) plans with the Mega Backdoor Roth option are best-suited for businesses where every employee is a Highly-Compensated Employee, or self-employed individuals or small business owners with no other full-time employees. Self-employed individuals with an Individual/Solo 401(k) plan can easily add a Mega Backdoor Roth option since they are generally not subject to any testing.