Window of Savings Opportunities With Backdoor Roth IRAs
OCTOBER 21, 2021
What is a mega backdoor Roth IRA? Can I do a backdoor Roth IRA in 2021? What is the limit to a backdoor Roth IRA? Is a backdoor Roth IRA worth it? Can I do a backdoor Roth every year?
Mega backdoor Roth IRAs have made headlines in recent months which likely means you have at least a few employees in your organization, especially highly compensated employees (HCEs), who are curious about the savings strategy and asking those kinds of questions. Understanding the strategy helps you answer their queries and provide guidance on the steps employees need to make the contributions.
Backdoor Roth IRA
To understand the concept that has become known as the mega backdoor Roth, it’s helpful to break down the terminology, starting with the Roth savings approach:
A Roth account refers to any account where retirement savings dollars are taxed initially when money is deposited into the account, but subsequent earnings and distributions are tax-free (assuming certain conditions are met). The Roth concept was created with the Roth IRA added by the Taxpayer Relief Act of 1997 (TRA 97) and extended to other retirement accounts beginning with the addition of Roth 401(k) accounts with the Economic Growth and Tax Relief Reconciliation Act of 2001.
Roth accounts can be more beneficial than traditional tax-deferred accounts if tax rates are expected to be higher during an individual’s retirement. These accounts can add an element of tax diversification if a portion of an account is Roth and another portion is a traditional tax-deferred account, which offers some protection against rising tax rates.
A backdoor Roth, as opposed to a mega backdoor Roth, refers to the ability to place money in a Roth account (historically, a Roth IRA) even if the individual is not otherwise eligible to make contributions directly into a Roth account. For the 2021 tax year, an individual earning more than $198,000 cannot make a full contribution into a Roth IRA or tax-deductible IRA and no contribution is allowed at all for individuals earning more than $208,000. Reduced income limits apply to tax-deductible IRA contributions for those covered by a retirement plan at work. However, an individual (regardless of income) can make a non-deductible contribution to a traditional IRA of up to the $6,000 annual limit. While the contribution receives no current favorable tax treatment, the income on contributions is tax-deferred until distributed.
As a result, these traditional IRA accounts typically offered limited value. This changed when a provision of TRA 97 sunset in 2010. TRA 97 introduced the concept of converting a traditional IRA to a Roth IRA by paying current income taxes on the amount converted. The ability to convert has a provision that precluded higher-income taxpayers from converting their traditional IRA contribution amount. That provision expired in 2010, and today, taxpayers of any income can make a non-deductible IRA contribution and then convert that amount into a Roth IRA.
Often, the conversion happens immediately after the contribution is made. It’s important to note that the conversion of non-deductible IRAs can create taxable income for any traditional IRA dollars that the taxpayer has saved.
A mega backdoor Roth takes the backdoor Roth to another level because the accounts may be part of an employer’s retirement plan. For decades, retirement plans have been allowed to permit employees to make after-tax contributions. From a tax perspective, the after-tax contributions are identical to non-deductible IRAs. However, these amounts are not limited directly to $6,000, but are limited in combination with other contributions by the Code 415(c) limit ($58,000 for 2021).
If an individual is deferring $19,500 in pre-tax and Roth deferral and receives employer contributions of $10,500, they can still make after-tax contributions of up to $28,000 ($58,000-$19,500-$10,500). However, there are numerous compliance issues (see the following discussion) that must be addressed before contributions of that size are permitted. Once in the plan, these after-tax amounts can either be converted to Roth dollars within the plan or distributed to a traditional IRA and then converted to a Roth IRA.
Setting a Mega Strategy
For employees who have more money to save after contributing the annual maximum to their 401(k)/403(b) accounts, your company’s retirement savings plan may provide a route to the mega backdoor Roth strategy if:
- The 401(k)/403(b) plan allows after-tax contributions, and
- In-plan Roth conversion option is allowed in the plan, or
- In-service distributions or withdrawals that are not hardship withdrawals from the plan to a Roth IRA are permitted
This savings tactic comes with a variety of risks. Employees should be strongly encouraged to discuss backdoor Roth options with their financial advisors. They will need to make sure they can afford to proceed with the savings strategy, and they will need to follow through carefully with each required step of the Roth conversion to reap the benefits.
The Pros to a Mega Backdoor Roth
The mega backdoor Roth savings approach offers several benefits to employees who make the Roth IRA conversion:
- No taxation on the earnings
- May withdraw the contributions at any time
- May withdraw the contributions and earnings tax-free for specific purposes (first-time home purchase, etc.)
- Withdrawal of the contributions and earnings is tax-free after age 59-1/2 (with five-year waiting period)
In addition, required minimum distributions at age 72 are not required from Roth IRAs; participants can leave their accounts untouched until a later age.
The Cons to a Mega Backdoor Roth
The strategy is not without caveats. While the mega backdoor Roth IRAs boasts several benefits, there are drawbacks that employees must weigh before implementing a mega backdoor Roth:
- Taxes must be paid on the accumulated earnings on the conversion at the time the conversion is made.
- Employees may not realize a benefit from the mega backdoor Roth IRA if their tax rate decreases in the future.
There’s a five-year waiting period before tax-free withdrawals can be made, even if you are 59-1/2 or older.
Attempts to Repeal
Since the income limits on conversions sunset in 2010, numerous congressional proposals have attempted to restrict or eliminate the ability for high-income individuals to utilize backdoor Roth IRAs and associated strategies. This includes a proposal as recent as September 2021 by the House Ways and Means Committee. Any retirement plan or individual utilizing these strategies should closely monitor the evolving legislative and legal landscape around these programs.
Plan Design Considerations
Plan sponsors should also consider their current plan design and plan participation to determine if adding an after-tax feature would be wise. Since after-tax contributions are subject to nondiscrimination testing (under the ACP test), several scenarios would likely lead to test failures, requiring refunds, and ultimately prohibiting the HCE from executing the strategy.
- If the plan does not provide a match, and mostly HCEs utilize the after-tax contributions, the ACP test would fail.
- If you currently provide a safe harbor match, those contributions are exempt from ACP testing, so the after-tax contributions would be tested alone. If mostly HCEs choose to make after-tax contributions, the ACP test would fail.
- If you currently provide employer matching contributions which would be averaged in with the after-tax contributions, the impact to the ACP test would be less severe. You should review how much the HCEs’ average contribution rates could increase before causing the test to fail.
- If you have a safe harbor plan, adding the after-tax source will void the top-heavy exemption you might otherwise have had. If the plan is determined to be top heavy, the employer must satisfy the minimum contribution requirements (generally 3% of pay) with respect to all non-key employees.
Understanding these cautions, plan sponsors should consider adding the backdoor Roth features if the plan:
- Is not a safe harbor plan;
- Provides a matching contribution;
- Passes ADP/ACP testing by a wide margin;
- Has broad participation and good deferral rates among non-highly compensated employees; and
- Automatically enrolls new participants, and regularly re-enrolls participants contributing less than the automatic deferral rate.
Through 401(k) and 403(b) plans, organizations of all kinds may offer opportunities for employees to implement a mega backdoor Roth IRA strategy. Reviewing your retirement savings plan and its provisions will allow you to answer inquiries from employees who are seeking additional ways to save and reduce taxes.