If you’re a personal finance nut you may have heard of a strategy called the “back door Roth IRA conversion.” This maneuver essentially allows you to contribute money to a Roth IRA, even if your income is otherwise to high to make a direct contribution. You make a non-deductible contribution to a traditional IRA, convert those funds to a Roth IRA, and presto! You have cash in the Roth that won’t ever be taxed again. While it seems like this is a glaring loophole in the tax code, Congress has endorsed the strategy in a conference committee report from the Tax Cut & Jobs Act.
But as great as it is to take advantage of Roth IRAs while you’re in high tax brackets, you’re still limited to the annual IRA contribution maximums of $6,000 per year (or $7,000 if you’re 50 or older). The “Mega” back door Roth conversion is a similar strategy, but allows for up to $37,000 per year in additional Roth contributions using a 401(k) plan.
Why the “Mega” Back Door Roth Conversion Strategy Works
The Three Types of 401(k) Contributions
To start, let’s review the three types of contributions you could make to a 401(k) plan. The first is the most common: your employee deferrals. You can instruct your employee to defer funds from your paycheck and deposit them on your behalf into the company’s 401(k) plan. Some plans allow you to make these deferrals on a Roth basis, and the limit in 2019 is $19,000 per year.
The second type of contribution is an employer contribution. This is anything your employer puts into the plan on your behalf, and includes matching contributions, or contributions based on a percentage of your compensation or company profitability. It may be subject to a vesting schedule, and is always made on a pre-tax basis.
The third, and widely unknown type of contribution is an after-tax deferral. Some 401(k) plans allow you to make additional contributions beyond your employee deferral on an after-tax basis, once you’ve reached the $19,000 annual limit. Note here that 401(k) plans are not required to allow this feature, and not all do.
There are two limitations to annual 401(k) contributions. The first is the $19,000 limit on employee contributions ($25,000 if you’re over 50 years old). The second is on the total amount contributed to the plan on your behalf. This limit is $56,000 in 2019, and consists of the three contribution types listed above.
So, to determine how much you could contribute in after-tax deferrals, you’d need to subtract $19,000 (again, $25,000 if you’re over 50) and the total amount of your employer contributions from $56,000.
Theoretically you could make up $37,000 per year in additional Roth IRA contributions using this maneuver ($56,000 – $19,000). You’d need to be under 50 though, and you couldn’t receive any contributions from your employer.
Just like with a standard back door Roth IRA conversion, the next step is to convert your non-deductible contributions to Roth balances. There are two ways to accomplish this, but both require specific provisions in the 401(k) plan.
The first method is what’s called an “in-plan Roth conversion”. Some 401(k) plans will allow you convert your traditional and/or after tax contributions to Roth balances, without taking a distribution from the plan. If your plan allows this type of conversion, you’d make your annual contributions, and then convert your after tax contributions to Roth balances within the plan, without a withdrawal.
401(k) plans come in many shapes and sizes, and it’s possible that yours might require you to convert your pre-tax employee deferrals at the same time you convert after-tax deferrals. This isn’t a big deal if those employee deferrals are Roth contributions. If they’re traditional contributions, an in-plan conversion would potentially add $19,000 of taxable income.
The second method uses a Roth IRA instead of in-plan Roth conversions. The IRS, according to Notice 2014-54, allows pre-tax 401(k) contributions to be rolled into a traditional IRA, and after-tax contributions to be rolled into a Roth IRA. This means that after making your initial contributions you’d withdraw the funds, rolling all pre-tax contributions (traditional employee & employer contributions) to a traditional IRA, and all after-tax deferrals (Roth employee & after-tax contributions) to a Roth IRA.
The catch is that just like an in-plan conversion, your 401(k) plan must permit you to withdraw your balances in the plan while you’re still employed. This feature is known as an “in-service withdrawal”. While in-service withdrawals are permitted by the IRS and department of labor, 401(k) plans are not required to allow them, and many don’t. Without this feature you wouldn’t be able to withdraw funds to execute the conversion – they’d need to stay in the plan until you separated from service.
So why not leave your after tax contributions in the 401(k) plan? Why is it so important to convert them to Roth balances? Just like your non-deductible contributions to a traditional IRA (like those you’d make in a regular back door Roth IRA conversion), you’ll be taxed on the growth of after-tax deferrals to a 401(k) plan.
Here’s an example. Let’s say that your employer makes no contributions to your company’s 401(k) plan for you, but allows after tax contributions. You max out your employee deferrals with Roth contributions of $19,000 per year. That leaves you with $56,000 – $19,000 = $37,000 of room to make after-tax deferrals.
Let’s say you do so, and over the subsequent five years your $37,000 grows into $60,000. If you withdrew everything you had in the plan, your Roth contributions (the original $19,000) would not be taxable as income. But since your $37,000 in after-tax deferrals were not in a Roth account, you’d have $60,000 – $37,000 = $23,000 added to your taxable income for the year. If you’d somehow gotten the $37,000 into a Roth account when you made the contribution (either through an in-plan conversion or an in-service withdrawal), none of the growth would be taxable.
In other words, if you decide to make after-tax deferrals, best practice is to convert the funds to a Roth account as soon as possible.
How to Set Up a 401(k) to Take Advantage of the “Mega” Back Door Roth
So what if you’re sponsoring a 401(k) plan yourself? How should you structure a 401(k) plan to take advantage of the mega back door Roth conversion?
As you probably guessed, you’d first need to include at least two of the provisions mentioned above in your plan. The first is after-tax deferrals, and unfortunately it’s not as simple as having your administrator add the provision to your 401(k).
Complications with After-Tax Deferrals
You may know that 401(k) plans come with annual compliance requirements. In exchange for offering such excellent tax advantages in 401(k) plans, the IRS wants to ensure that plans benefit rank and file employees in addition to business owners. To comply with such requirements, the IRS requires sponsors to undergo “top-heavy” testing every year.
For smaller 401(k) plans, a convenient way to skip the compliance testing is to include a “safe harbor” provision. Basically, the IRS says that if plan sponsors make certain employer contributions that vest immediately, they don’t need to undergo any compliance testing. Sponsors have the choice between a generous match, or a “non-elective” contribution that’s a flat percentage of employees’ compensation.
Thousands of 401(k) plans around the country utilize this safe harbor provision, since it’s a streamlined way to operate a 401(k) plan. And unfortunately, the after-tax contributions used in a mega back door Roth conversion “blow up” the safe harbor. This may not be a big deal if your 401(k) plan is already going through annual compliance testing. But if you’re using the safe harbor to save on some operational headache, you should know that after-tax deferrals circumvent the safe-harbor provision, as they could make your plan top-heavy.
If you’re comfortable with the compliance landscape and decide to offer after-tax deferrals, you’ll also need a conversion mechanism. As I mentioned above, this could be through either an in-plan conversion or an in-service withdrawal.
Either can work. Sponsors should know that in-service withdrawals can sometimes open Pandora’s box, as they allow assets to leave the plan before separating from service. This can affect pricing from vendors like recordkeepers or custodians. Typically, the more assets you have in the plan, the better pricing tiers providers can offer. Assets flowing out of the plan could result in higher operating costs.
Solo 401(k) Plans
Mega back door Roth conversions can work with solo 401(k) plans as well. Just know that the typical solo 401(k) you’d open at a discount brokerage firm will not offer the features you’ll need to execute the strategy. Vanguard, Charles Schwab, TD Ameritrade, etc. all offer wonderful low cost investing solutions, but their solo 401(k) options are all standardized, boilerplate plans. (That’s how they can offer them for free). You can certainly set up a solo 401(k) plan for yourself to allow for the mega back door Roth conversion. You’ll just need the help of an independent administrator.