Did you know that if you are self-employed, you can make Roth contributions of up to $61,000 or $67,500 if you are age 50+ for 2022, even though we’re in 2023? This article will explore the mysterious, but 100% legal, Mega Backdoor Roth 401(k) option.
The Mega Backdoor Roth is the only strategy that will allow a self-employed individual or small business owner with no employees to contribute up to $61,000 of $67,500 in 2022 ($66,000/$73,500 in 2023) in a Roth and potentially get immediate access to the cash. In contrast, the Roth IRA maximum contribution limit is $6,000 or $7,000 for 2022 ($6,500/$7,500 in 2023).
What is a Solo 401(k)?
A Solo 401(k) plan is not a new type of retirement plan. It is a traditional 401(k) plan covering only one employee. In general, to be eligible to establish a Solo 401(k), one must be self-employed or have a small business with no full-time employees other than a spouse or other owner(s).
Can I Set up a Solo 401(k)?
A Solo 401(k) plan is well suited for businesses that either do not employ any employees or certain employees that may be excluded from coverage. It is perfect for any sole proprietor, consultant, or independent contractor. To be eligible to benefit from the plan, you must meet just two eligibility requirements: the presence of self-employment activity and the absence of full-time employees.
The business owner(s) and their spouses are technically considered “owner-employees” rather than “employees.” So long as there are no other full-time employees at the business, you can “go Solo.”
Why Choose a Roth?
Like a Roth IRA, a Roth 401(k) is an after-tax account that can grow tax-free. However, unlike a Roth IRA, a Roth 401(k) does not have any income limitations. Not all 401(k) plans offer a Roth option, however, over the last several years most new plans will allow for Roth contributions.
The primary advantage of going Roth is that once the 401(k)-plan participant is over the age of 59 1/2 and any Roth has been open for at least five years, all distributions are tax-free.
Roth Solo 401(k) Contributions
Under the 2022 Solo 401(k) contribution rules, a plan participant under the age of fifty can make a maximum annual employee deferral contribution in the amount of $20,500 ($22,500 for 2023). That amount can be made in pre-tax, after-tax, or Roth. On the profit-sharing side, the business can make a 20 or 25 percent contribution based on the amount of the net Schedule C amount or W-2, as applicable, up to a combined maximum, including the employee deferral, of $61,000 ($67,000 for 2023). If you are at least age 50, you may contribute an additional “catch-up” contribution of $6,500 ($7,500 in 2023).
It is important to remember that only earned income can be contributed to a Solo 401(k) plan. Earned income includes all the taxable income and wages you get from working for someone else, yourself, or from a business you own. In addition, one cannot contribute more than they earn into a retirement plan.
The Mega Backdoor Roth 401(k) Advantage
Before I dive into the details involving the Mega Backdoor Roth 401(k), it is important to understand the basic rules behind 401(k) plan contributions. First, you can contribute pretax funds to a “traditional” 401(k). The amount contributed will lower your tax bill for the year which offers you an immediate tax break. Taxes are deferred until you withdraw from the plan. Next, you can go Roth, but only the employee deferral can be made as Roth. These contributions are made with after-tax funds, so there’s no immediate tax break. As mentioned above, all qualified Roth withdrawals are tax-free.
Lastly, there is the straight, after-tax contribution. There is no upfront tax break, and distributions are taxable (since they are not Roth), so why do it? One reason is that high-income earners want to hold assets in a tax-advantaged account, and this is their only option. However, the majority of those who make after-tax contributions is to convert them to Roth.
After-tax contributions are not subject to Internal Revenue Code Sections 402 and 404 limits but must satisfy the Section 415 limits. In other words, after-tax contributions are not treated as employee deferral or employer profit-sharing contributions. They are in their own separate category.
How Does the Mega Backdoor Roth Work?
The basic premise of the Mega Backdoor Roth 401(k) strategy is that one can convert after-tax contributions to Roth without being limited to the employee deferral cap or the employer profit-sharing percentage caps. Since the contributions made will be after-tax, there would be no taxes due on a Roth conversion. In addition, thanks to IRS Notice 2014-54, after-tax contributions can now be converted to Roth in the 401(k) plan without limitation to any pro-rata rules that existed prior to the notice.
Steps to do the Mega Backdoor Roth 401(k)
- Establish a Solo 401(k) plan
- Open a bank account for the plan
- It is suggested that three sub-accounts be established: (i) pretax, after-tax, and Roth (which will make plan accounting easier)
- Make after-tax contributions to the plan, which can be made dollar for dollar up to the annual limits
- Immediately convert those funds to Roth. The funds should go from the after-tax bank account to the Roth bank account.
- The funds converted to Roth can stay in the plan or be moved to a Roth IRA.
- The 401(k)-plan administrator will file a 1099-R reporting the conversion
Mega Backdoor Roth & the Solo 401(k)
The Mega Backdoor Roth 401(k) option can generally only be used by Solo 401(k) plan participants. The reason for this is that Solo is not subject to ERISA testing. Whereas, in a 401(k) plan with non-owner employees, such as Apple, unless enough rank-and-file employees elected to do the mega contribution, which rarely happens, and too many highly compensated employees elect to do so, the plan would fail the ERISA test and the contribution would be disallowed.
Can I still do the Mega Backdoor Roth 401(k) for the 2022 Taxable Year?
Since these contributions are not treated as either employee deferral or employer profit-sharing contributions, they are not subject to any of those contribution rules. Hence, Mega Backdoor Roth 401(k) contributions can be made up until the business that adopted the plan files its tax return, including extensions. In addition, even if the business just established the plan in 2023, contributions can still be made for the 2022 taxable year.
The Mega Backdoor Roth 401(k) is the ultimate tax strategy for Roth lovers. The reason it is not more popular is that, in most cases, only Solo 401(k) plans can take advantage of the solution because of the ERISA rules. Plus, not all plan providers offer the option, so it is important to ask your plan document provider before getting started.
And now, because of changes in law, you don’t even have to have the plan established during the year you wish to contribute. So long as the plan is adopted before you file your taxes, you can still take advantage of the Mega Backdoor Roth structure. If you are self-employed and want to save as much as you can in a Roth, look no further than IRA Financial to establish your Solo 401(k).