Background
There is growing interest in a design strategy known as the Mega Backdoor Roth Conversion (the Conversion). The Conversion allows 401(k) or 403(b) Plan participants who are already deferring the maximum allowed to contribute After-Tax funds to the plan. The participant may then convert the money from After-Tax funds to Designated Roth funds. This two-step process has the effect of allowing plan participants to contribute additional Roth money to the plan and shelter the gains from taxes.
Questions and Answers?
Q1: Why does this work?
A1: The After-Tax contribution works because each of the three types of participant contributions to a 401(k) or 403(b) plan has different contribution rules. The following table details the contribution and taxation differences.
The Conversion works because the Roth conversion of After-Tax accounts is independent of the contribution. The IRS explicitly authorized the ability to convert After-Tax funds to Roth funds in 2015.
Q2: Why would a participant execute a Mega Backdoor Roth Conversion rather than contribute After-Tax and leave it in the After-Tax source?
A2: A participant would want to have money designated as Roth rather than After-Tax as the gains become tax free when withdrawn after satisfaction of the 5-year rule.
Q3: What about the income limit on making Roth contributions?
A3: The income restriction on Roth contributions is an IRA limit, not a qualified plan limit. Designated Roth deferrals into a 401(k) plan have no income test. Additionally, this is an After-Tax contribution that is then converted to Roth.
Q4: When would Sapers & Wallack recommend that a client not add the Conversion?
A4: If participants are not contributing at an amount that would provide deferrals up to the $19,000 / $25,000 limit, the participant should increase their 401(k) or Roth deferral percentage to maximize their deferrals prior to executing a Conversion. If the plan does not have participants who maximize their deferrals and would like to shelter more money, Sapers & Wallack would not recommend installing a Conversion process.
Also, if:
- The plan does not have a matching contribution; or
- The plan does not currently pass the match nondiscrimination test by a comfortable margin; or
- The plan would fail the nondiscrimination test if not for a Safe Harbor Match provision;
Sapers & Wallack would not recommend installing the Conversion provisions as After-Tax contributions to the plan require nondiscrimination testing with the match, and a failing test or low NHCE Conversion percentages would severely limit or eliminate the ability for HCE Conversions.
Q5: How much can a participant contribute on an After-Tax basis to later convert to Roth?
A5: The After-Tax contribution amount is limited to $56,000 or 100% of pay, reduced by:
- 401(k) & Designated Roth Deferrals
- Matching Contributions
- All other employer contributions
NOTE: The $56,000 limit is not reduced by Over-Age-50 Catch-Up contributions.
The following are two examples of how all the contributions work together to determine the maximum allowable After-Tax contribution. The examples assume matching contributions of 100% of pay on contributions up to 6%.
NOTE: Employers may wish to limit the After-Tax contribution to less than the maximum allowed by law. Sapers & Wallack can work with you to determine an After-Tax contribution policy to help with efficient administration of the contribution and Conversion.
Q6: What are the plan requirements to add the Conversion and steps required to execute a Conversion?
A6: Sapers & Wallack will work with you to:
- Determine an appropriate After-Tax contribution policy to limit the contributions as necessary;
- Amend the plan document; and
- Create workflows to make the Conversion as easy as possible for you and your employees.
Summary
The Mega Backdoor Roth Conversion allows a plan participant to take advantage of the different rules governing 401(k) Deferrals and After-Tax contributions and the IRS Notice authorizing Roth conversions of After-Tax accounts to contribute beyond the standard $19,000/$25,000 limit. While the Conversion is not right for every client or participant, for super savers and top earners, it can be a way to increase tax deferred savings and take advantage of the institutional fund lineup of their company’s 401(k) Plan.
As always, we are here and ready to help you secure the best path forward.
