Recent reporting with reminders about the potential power of the “Mega Backdoor Roth” conversion strategy in a 401(k) plan has been compelling. Who wouldn’t like to contribute as much as $58,000 to their 401(k) and not have to pay taxes in the future? Like most things in life, there are rules, caveats, and limitations. Unfortunately, these realities don’t get much discussion in the press articles. What ends up happening is you ask about the Mega Backdoor Roth at work only to find out it is not available and/or does not work in your plan. The reasons this strategy does not always work are essential to understand. If the Mega Backdoor Roth is not possible at your company, it also doesn’t mean you have a lousy retirement plan.
To take the first step in the Mega Backdoor Roth conversion process, you must start contributing to the “traditional” after-tax money source in your retirement plan. Not to be confused with the more commonly known Roth option. However, to even get started, the after-tax option must be available in your 401(k) plan. According to the recently released 2021 version of the Vanguard study “How America Saves,” only 1 of 5, or 19% of retirement plans offer the ability to make after-tax contributions. If your employer does not already provide this contribution option, they will need to amend their 401(k) plan to add it. Depending on the size of your employer, this could be a simple process and made available for you quickly, or one that is more complex and involves internal committees and even lawyers.
Next, assuming your employer now allows for after-tax contributions and you have started making them, your plan provider must go through a process to test them. Once the year is complete, you and your co-workers’ contributions are subject to what is commonly known as discrimination testing. Depending on certain details like your plan participation rate, the amount and type of employer matching, and the after-tax contributions levels in your plan, testing may or may not pass. If you are a Highly Compensated Employee (HCE), this could be problematic. If you are considered a Non-Highly Compensated Employee (NHCE), you don’t need to worry. The general method to fix a failed discrimination test is to return contributions to the HCEs.
Often when an employer introduces the Mega Backdoor Roth concept, only HCEs participate. Vanguard’s data confirms that the highest utilization of after-tax contributions is by those making $150,000 or more annually. The second highest is by those making between $100,000 and $149,999. Retirement plan participants with income of less than $100,000 have very low utilization of after-tax compared to the top two income groups in the study. Many employees in the two upper-income ranges mentioned are considered HCEs. If a disproportionate amount of HCEs participate in the after-tax strategy, your plan’s discrimination testing is unlikely to pass. As a result, the HCEs would need some or all of their after-tax contributions returned to them to correct the failed discrimination test.
One way to gauge the probability of whether your plan could pass the required testing is if you have a 401(k) match. The Mega Backdoor Roth strategy has a very low chance of success if your plan does not offer a match. Your after-tax contributions are tested with employer matching contributions under the Average Contribution Percentage (ACP) test. To add another dose of reality, Vanguard, in their report, also cites that only 10% of employees who are eligible to make after-tax contributions take advantage of them. So, if your plan does not match, you will not likely have enough participation by NHCEs to help the required annual testing pass. To use an extreme but unfortunately common example, if only HCEs make after-tax contributions, and your plan does not have a match, the ACP test will fail. In this case, each HCE who contributed would have all of their after-tax dollars reversed and returned to them. If you “maxed-out” your after-tax contributions, you would have lost an entire year of savings in your 401(k) plan. This example is a key reason why some employers do not make this strategy available.
Once you have made your after-tax contributions, you must convert them into Roth dollars to complete the process. This step also needs researching prior to heading down the Mega Backdoor Roth path. You have two options, either use the “In-Plan Roth Conversion” feature if it is available in your plan, or take an “In-Service Distribution” of your after-tax contributions. According to the same Vanguard report, just over 1 of 5, or 22% of workplace retirement plans, offer the ability to perform an in-plan Roth conversion. For the second option, an in-service distribution allows you to withdraw money from your 401(k) plan while you are still employed. During the process you would request your distribution then be rolled over to a personal Roth IRA outside your 401(k) plan to complete the Roth conversion. The distinction here is that many 401(k) distribution options don’t get activated until you have separated from service from your employer. If your plan offers the after-tax contribution option, it is more common it would also allow for an in-service withdrawal of those contributions.
Keep in mind, in 2021, the aggregate IRS contribution limit is $58,000 for a variety of methods you or your employer may deposit money into your 401(k) account. If you are trying to max out your Mega Backdoor Roth strategy, your actual limit will be reduced by any pre-tax or Roth contributions you make during the year. If you receive a match or profit-sharing contribution from your employer, these will also reduce the total amount available to you for after-tax contributions.
Another consideration, if your plan offers a match, read your plan document or ask your employer if they match on after-tax contributions. 401(k) matching in retirement plans is generally treated similarly for pre-tax and Roth contributions. However, the match is not always applied to after-tax contributions. In an attempt to maximize the size of your Mega Backdoor Roth, you could miss out on your employer match.
The Mega Backdoor Roth is a compelling option to accelerate your retirement savings and shield them from taxes in the future. If your plan allows for it, you have a strong match and plan participation rates; it very well may work. However, based on the demographics of your employer and your plan rules, it might not be feasible. This indeed is a powerful benefit to look into with your employer, but it just might not work to the full extent you would hope or even at all in your plan.