If you are a Roth lover and are self-employed or have a small business with no full-time employees, then you absolutely need to keep reading and learn more about the secret Roth solution known as “the mega backdoor Roth 401(k).”
The mega backdoor Roth strategy is the only strategy that will allow a self-employed individual or small business owner with no full-time employees (1000 hours or three consecutive years of 500 or more) to contribute in 2024 up to $69,000 ($66,000 for 2023) or $76,500 ($73,500 for 2023) to a Roth and potentially get immediate access to the cash tax-free. In contrast, a Roth IRA contribution maximum contribution limit is $7,000 or $8,000 if over the age of 50 for 2024, which is subject to income limitations.
How the Mega Backdoor Roth Works
The mega backdoor Roth 401(k) option can generally only be used by solo 401(k) plans. The reason for this is that a solo 401(k) plan is not subject to ERISA testing. Whereas, in a 401(k) plan with non-owner employees, such as Tesla, will generally not be able to offer a “mega backdoor Roth” 401(k) solution unless enough rank-and-file employees selected to do a “mega backdoor Roth” contribution, which rarely happens. In other words, as a result of the ERISA testing, specifically the top heavy and ACP test (Actual Contribution Percentage), if too many highly compensated employees (earn more than $155,000 in compensation) for 2024 elect to make “mega backdoor” Roth contributions in relation to rank and file employees, the 401(k) plan would fail the ERISA test and the contribution would be disallowed.
Under the mega backdoor Roth strategy, a solo 401(k) plan participant can make after-tax contributions up to a maximum of $69,000 or $76,500, if over the age of 50 for 2024. The plan participant must have sufficient earned income (Schedule C net income) or W-2 income to make the after-tax contribution. The “mega backdoor Roth” contributions are made on a dollar-for-dollar basis and are not based on a percentage of income, such as an employer profit-sharing contribution. In other words, the “mega backdoor Roth” contributions look more like employee deferrals as they are both made on a dollar-for-dollar basis. In addition, one cannot contribute to a plan more than they earn, so the plan participant mustn’t contribute more than they earn. For example, if a plan participant made a net $40,000 on her Schedule C, the after-tax contributions could not exceed that amount. Note – you may not be able to contribute the entire amount earned as the contribution must be net of social security and Medicare taxes.
Hence, assuming a plan participant had $90,000 of net Schedule C income, she would be able to do an after-tax solo 401(k) plan contribution of $69,000 or $76,5 in 2024. The plan participant would then immediately either convert the funds in the plan to Roth or roll the after-tax funds to an after-tax IRA and then immediately convert the funds to a Roth IRA. After-tax contributions are not considered employee deferral or employer profit-sharing contributions and are, thus, not subject to the 401(k) plan triggering rules. Whereas, in the case of employee deferrals, for example, the plan triggering rules essentially restrict a plan participant from rolling over 401(k) plan funds to an IRA or another plan or taking a distribution, except for certain hardship exceptions, until they reach the age of 591/2, their job is terminated, or the plan is terminated.
Roth IRA Distribution Rules
Prior to IRS Notice 2014-54, doing a “mega backdoor Roth” 401(k) was not as attractive as there was some uncertainty as to how the after-tax 401(k) funds could be rolled over to a Roth IRA. Notice 2014-54 clarified this rule and allowed the pre-tax and after-tax funds that were distributed from a plan on a pro-rata basis to be separated once a distribution is made. Therefore, IRS Notice 2014-54 opened the door to the “mega backdoor Roth” 401(k) strategy.
Procedure for Doing a Mega Backdoor Roth
When doing a “mega backdoor Roth” 401(k) solution, the after-tax contributions are made to the solo 401(k) plan by the employee. We suggest opening a separate bank account for the after-tax funds. Immediately thereafter, the after-tax funds would be rolled into a Roth bank account under the plan. Again, for simplicity purposes, we suggest opening a separate Roth bank account. Hence, a plan doing a “mega backdoor Roth” solution would typically have three bank accounts under the plan: pre-tax bank, after-tax, and Roth. This is not required but based on our experience highly recommended.
Deadline for Making a Mega Backdoor Roth Contribution
The deadline for making a “mega backdoor Roth” contribution is the date the adopting employer files its tax return, including extensions. Because the contribution is after-tax funds, it does not impact the individual’s federal income tax return (IRS Form 1040). You can even set up a plan immediately before the adopting employer files their tax return and take advantage of the “mega backdoor” Roth solution. For example, one can set up a solo 401(k) plan on April 14, 2024, and make a “mega backdoor” Roth contribution for the 2023 taxable year.
Conclusion
The “mega backdoor Roth” Solo 401(k) strategy is the ultimate strategy for maximizing one’s Roth contributions. Not all solo 401(k) plans include the “mega backdoor Roth” option. For example, a solo 401(k) plan offered by a brokerage firm will typically not include the option. IRA Financial is one of the few solo 401(k) plan providers that offer and specialize in the design and administration of the “mega backdoor Roth” option.
