Every year, the financial press seems to write about the so-called Backdoor Roth and Mega Backdoor Roth strategies in 401(k) plans, and this year is no exception. (Maybe the Super Duper Mega Backdoor Roth will be next year.) The difference is that the articles usually start to appear closer to the Fall, but they are trending earlier this time around.
Spoiler Alert: These sound smart, sexy, and cool, but they rarely work, especially in the small plan marketplace. In fact, if you are an advisor or other service provider with the goal of sounding great to your clients, it can actually backfire for those that setup client meetings on the topic without knowing the details.
What is a Backdoor Roth IRA?
Our article in Kiplinger from a few years back provides the detailed answer, but here is the TL;DR. The Backdoor Roth IRA has nothing to do with a 401(k), but some seem to be a bit confused with these backdoor strategies. Taxpayers that cannot make direct contributions to a Roth IRA due to income limits can still get there by going through the backdoor. Here’s how it works. The individual deposits the maximum amount permitted into a traditional IRA and immediately converts it into a Roth IRA. As you will read in the linked article, this is not practical for someone who already has a traditional IRA balance.
What is a Mega Backdoor Roth?
This backdoor encourages participants in 401(k) plans to defer after-tax dollars to the plan. To clarify, we’re not talking about Roth deferrals (which are also post tax at the time of contribution). This is the old school type of after-tax contribution in which the earnings are taxed at distribution from the plan. After-tax contributions are generally capped at the overall annual additions limit of $58,000 for 2021 (or $64,500 if over age 50) rather than the regular deferral limit of $19,500 for 2021 (or $26,000 if over age 50). The annual additions limit includes all contribution sources such as profit sharing, company match, deferrals, and after tax, while the deferral limit only considers pre-tax and Roth deferrals.
The Mega Backdoor Roth comes into play in one of two ways. The individual either takes an in-service withdrawal and rolls it to a Roth IRA or utilizes an in-plan Roth rollover feature to convert to Roth within the plan.
This may sound like a complicated cool investment strategy, but it RARELY works. Our article published in 2014 provides the lowdown, but here is a quick summary.
- While many plans allow Roth deferrals, very few permit after tax contributions, especially in the smaller plan marketplace.
- Having both Roth and traditional after-tax contributions in the same plan increases difficulty with both payroll and recordkeeper. (Okay, it’s not THAT difficult for companies that have solid technology and the understanding of the nuances, but it is imperative that plan sponsors categorize contributions correctly for Form W-2 purposes and ongoing plan recordkeeping, including tracking of tax basis.)
- If a participant maxes out after-tax contributions and then the company makes a year end profit sharing contribution, that participant has now exceeded the annual additions limit. Sure, those excesses can be corrected, but it needlessly adds complexity and cost to the plan. Not to mention, it doesn’t make for very happy participants.
- Perhaps, the biggest fly in the ointment is that after tax contributions are subject to the ACP test. Yes, even in safe harbor 401(k) plans.
- Another drawback for safe harbor 401(k) plans is that making after-tax contributions voids the top-heavy exemption.
We should focus on those last two bullet points for a minute. It is probable that the plan’s highly compensated employees are the only ones who can afford to contribute more than $26,000 per year on an after tax basis. That means the ACP test is virtually guaranteed to fail, resulting in some or all of the contributions being kicked back out of the plan. If the plan is a safe harbor plan that is top-heavy, layer on the double-whammy of losing the top-heavy exemption, and here is how it plays out.
- Some or all of the HCEs make big after-tax contributions.
- The ACP test fails because few, if any, non-HCEs make those same contributions.
- The HCEs have most, if not all, of their after-tax contributions refunded to them, which means no Roth conversion.
- Due to the loss of the top-heavy exemption, the plan sponsor is now required to contribute 3% of pay for all non-officers and owners. Ouch!
The result is the potential of significantly increasing the cost of the plan while irritating the HCEs by pulling that super cool contribution strategy right out from under them. Talk about a lose-lose scenario.