If you are a Roth lover and are self-employed or have a small business with no non-owner full-time employees, then you need to learn about the Mega Backdoor Roth 401(k) option. The good news is that the Mega Backdoor Roth Solo 401(k) plan remains an option in 2022 as of the date of this article.
The Mega Backdoor Roth strategy is the only one that will allow a self-employed individual or small business owner with no employees to contribute up to $61,000 or $67,500 in 2022 in a Roth and potentially get immediate access to the cash. In contrast, a Roth IRA maximum contribution limit is $6,000 or $7,000 if over the age of 50, which is subject to income limitations.
How Does the Mega Backdoor Roth 401(k) Work?
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, 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 elect to initiate Mega Backdoor Roth contributions in relation to rank and file employees, the 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 $61,000 or $67,500, if over the age of 50 for 2022. The plan participant must have sufficient earned income (Schedule C net income) or W-2 income to make the after-tax contribution. One cannot contribute to a plan more than they earn, so it is important that the plan participant not contribute more than they earn. For example, if a plan participant made net $40,000 on her Schedule C, the after-tax contributions could not exceed that amount. Note as well that you may not be able to contribute the entire amount earned as income, as the contribution amount must be net of social security and Medicare taxes.
Hence, assuming the plan participant had $80,000 of net Schedule C income, she would be able to do an after-tax Solo 401(k) plan contribution of $61,000 in 2022. The plan participant would then immediately either convert the funds in the plan to Roth or the 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 59 1/2, their job is terminated, or the plan is terminated.
Roth IRA Distribution Rules
Prior to IRS Notice 2014-54, doing a Mega Backdoor Roth IRA 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.
The Build Back Better Bill
In November 2021, the House narrowly passed the Build Back Better (“BBB”) bill, approving $2.2 trillion in spending over the next decade to battle climate change, expand health care, and reweave the nation’s social safety net, over the unanimous opposition of Republicans. However, as a result of Sen. Joe Manchin, D-W.Va. opposition, the Bill was not able to pass the Senate and is currently inactive. The Bill contains several retirement related provisions, including a provision that would eliminate the Mega Backdoor Roth conversion option by prohibiting the conversion of after-tax contributions to Roth for 2022 and beyond. This provision would also eliminate the Backdoor Roth IRA.
However, the BBB is currently not law. Hence, as of the time of the writing, the Mega Backdoor Roth 401(k) solution is still a legal option. If some revised form of the BBB is passed in 2022, which includes the provision which eliminates the Mega Backdoor Roth 401(k) option, the question then becomes will the prohibition apply in 2022 or 2023. According to industry sources on the Hill, the thought is that if the BBB does not get passed before March 2022, there is a solid chance the Bill will allow for the Mega Backdoor Roth 401(k) option for the 2022 taxable year, but eliminate the option for 2023 and beyond. Of course, there is still a chance that the revised BBB will not include the provision eliminating the Mega Backdoor Roth 401(k) and the Mega Backdoor Roth IRA.
As of March 2022, the Mega Backdoor Roth 401(k) option is still alive. Therefore, Roth lovers who are self-employed or have a small business with no full-time employees wishing to make Roth contributions of up to $58,000 ($64,500 if over 50) for 2021 or $61,000 ($67,500 if over 50) should strongly consider going Solo. The good news is that you can set-up a Solo 401(k) plan in 2022 and still take advantage of the Mega Backdoor Roth Solo 401(k) option for the 2021 taxable year. With respect to the 2022 taxable year, we will have to wait and see what the revised BBB looks like and whether it contains the provisions eliminating the Mega Backdoor Roth Solo 401(k) option. Until that time, it may be a good idea to do a Mega Backdoor Roth Solo 401(k) contribution as soon as possible, because there is a good chance the relevant BBB provision will not contain retroactive exemption language.