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.
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.
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.
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.
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.