The new tax proposal introduced by the House Ways and Means committee may eliminate the Mega Backdoor Roth 401(k). The provision would prohibit anyone, not just high-income earners, from performing this valuable retirement planning strategy. In the following, we’ll tell you what a Mega Backdoor Roth 401(k) is and why you should consider it.
- The Mega Backdoor Roth 401(k) allows the self-employed to supersize his or her Roth savings
- The latest tax proposal could eliminate this strategy for ALL Americans
- If you are self-employed, you should consider the backdoor Roth before it’s gone
Solo 401(k) Eligibility
First off, we need to talk about the Solo 401(k) plan. Why? Because, the Mega Backdoor Roth 401(k) strategy can usually only be done by the self-employed. Because of 401(k) plan testing, you need enough employees covered by the plan to choose to perform this strategy. If not enough employees choose to contribute enough, the plan will fail ERISA testing. Since a Solo 401(k) plan generally only covers you, there is no testing.
The Solo 401(k) is like a traditional 401(k) Plan. To become Solo 401(k) eligible, one must not have any employees that work over 1000 hours and are non-owners. So long as the business does not have any non-owner, full-time employees, the owner(s) and spouse(s) can establish a Solo 401(k) plan for the business.
Solo 401(k) Plan Contribution Rules
Internal Revenue Code (IRC) Section 402g imposes a per individual limit of $19,500 or $26,000 if over age 50 for 2021. Employee deferral contributions can be made in pretax or Roth, if the plan document permits. Employee deferral contributions are made dollar for dollar and are not based on a percentage of income. Whereas, employer profit sharing contributions can be made to the plan in an amount up to 25% of the participant’s self-employment compensation (20% in the case of a sole proprietorship or single member LLC). Employer profit sharing contributions must be made in pretax. The total amount one may contribute to his or her 401(k) plan for 2021 is $58,000 or $64,500 if age 50+.
There is a way you can contribute the entire amount on a dollar-for-dollar basis. Welcome to the Mega Backdoor Roth 401(k) strategy.
After-tax contributions are not considered pretax or Roth. After-tax contributions are not tax deductible and the earnings are subject to tax. Obviously, this is not a smart way to save. You don’t get the upfront tax break of a pretax contribution or the tax-free withdrawals of the Roth. However, in the Mega Backdoor Roth 401(k) strategy, after-tax contributions is where it’s at.
In other words, one can reach the maximum plan contribution limits with less income utilizing the Mega Backdoor Roth than by using a mix of employee deferral and employer profit sharing contributions. Unfortunately, not all Solo 401(k) plans allow for after-tax contributions
Mega Backdoor Roth 401(k) Strategy
Under the Mega Backdoor Roth strategy, a Solo 401(k) plan participant can make after-tax contributions up to the annual limits. The plan participant must have sufficient earned income (Schedule C net 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 only contribute what he or she is allowed.
Assuming a plan participant had $70,000 of net Schedule C income, he or she would be able to make an after-tax contribution of $58,000 in 2021. The plan participant would then immediately roll the after-tax funds to an after-tax IRA. He or she can then immediately convert the funds to a Roth IRA.
Further, after-tax contributions are not subject to the plan triggering rules. Therefore, one can move those funds out of the plan, even if they are still an active participant. Pretax and Roth contributions need that triggering event. Without one, they funds must stat in the plan
Roth IRA Distribution Rules
Prior to IRS Notice 2014-54, doing a Mega Backdoor Roth 401(k) was not as attractive. There was some uncertainty as to how the after-tax 401(k) funds can be rolled over to a Roth IRA. Notice 2014-54 clarified this rule and allowed the pretax and after-tax funds that were distributed from a plan on a pro-rated basis to be separated once a distribution is made.
In short, you make the after-tax contribution to your 401(k) plan, roll them over to an IRA, and then convert them to a Roth. You now have supersized your Roth savings through the backdoor. You will then be able to invest those funds however you want. The best part is that all qualified distributions from the plan will be tax free!
In order to take funds out of a Roth IRA tax-free, the distribution must be deemed a qualified distribution. A qualified distribution is when any Roth IRA has been opened at least five years and the Roth IRA owner is over the age of 59 1/2. If you satisfy the qualified Roth IRA distribution rules, Roth IRA distributions of contributions and earnings will be tax-free. However, contributions to a Roth IRA can always be taken anytime as a tax-free distribution. Note, the five-year rule for a 401(k) plan is counted separately from the five-year rule for any/all Roth IRAs.
Distributing a Roth Conversion
Roth IRA distribution rules on conversions are somewhat different than distributions on Roth IRA contributions. With respect to Roth IRA conversions, the conversion ordering rules hold that distributions are first made form after-tax contributions, then conversions, and finally earnings. Also, each Roth IRA conversion has its own five-year period.
In the case of a Mega Backdoor Roth 401(k) strategy, once the after-tax IRA funds are converted to Roth, they can actually be taken as a distribution without satisfying the five-year rule since the conversion came from after-tax funds. Alternatively, if the converted funds came from earnings, the five-year rule would apply even to a distribution on the converted amount, unless the individual was over the age of 59 1/2.
The Mega Backdoor Roth 401(k) is not widely known – but should be. The strategy can help Roth lovers supercharge their Roth accounts and at the same time provide greater investment and distribution options.
However, this may all change is the latest tax proposal gets enacted. The government is worried about someone amassing tens of millions of dollars in a Roth account. Unlike the Backdoor Roth IRA, which will be prohibited based on income, the Backdoor 401(k) will be disallowed for all. Take advantage of this exciting retirement planning tool while it is still available!