Can retirement plan participants do mega backdoor Roth 401(k) every year?

Defined contribution (DC) plans go a long way in helping Americans save for retirement. But IRS limits keep some people from maximizing their savings in ways that help them minimize their taxes. Adding a mega backdoor Roth feature to your company’s 401(k) plan can enable your high-earning employees to save more—and, yes, they can do it every year it’s available in their plan.

Why? Because the IRS limits 401(k) contributions 

In 2021, the IRS caps employee pretax 401(k) contributions at $19,500 and contributions from all sources (pretax, after tax, and employer) at $58,000. The difference between the two limits, $38,500, is a gap that some employees, especially those with higher incomes, may want to take advantage of. Although employer contributions can help fill this gap, there’s still usually room to save more.

After-tax contributions, if permitted by the plan, allow participants who want to save more in their 401(k) to do so—up to the $58,000 limit. Even when a plan permits after-tax contributions, however, it may not make sense for a participant to use them. That’s because earnings on the after-tax contributions are taxed as regular income upon distribution—whereas, if they saved outside the plan in a taxable brokerage account, the gains may be taxed at a lower capital gains rate. But that doesn’t mean there’s no tax-friendly way for your employees to save up to the $58,000 maximum for all contributions. 

There's a $38,500 gap between the DC limit and the pretax 401(k) limit

Graphic shows the 2021 401(k) contribution limits: $19,500 pretax and $58,000 defined contribution, leaving a $38,500 gap

How mega backdoor Roth 401(k) can help close the gap

The mega backdoor Roth 401(k) is a technique that combines two features: after-tax contributions and a Roth 401(k) that allows after-tax Roth conversions (of which the allowable number per year is set by the plan sponsor). When you offer both features, participants can take full advantage of the $58,000 annual addition limit in 2021 and close the 401(k) savings gap by:

  • Making after-tax contributions, and
  • Converting those contributions, plus earnings, to a Roth 401(k). 

Future earnings are tax free, if the participant meets Roth distribution rules. 

Mega backdoor Roth 401(k) example

Let’s see how a mega backdoor Roth can help a participant save more and minimize future taxes. Consider: 

  • A plan with a 5% dollar-for-dollar employer match, and 
  • A participant with an income of $100,000 per year, who contributes $19,500.

The total amount contributed by the employer and participant comes to $24,500. The resulting gap is $58,000, minus $24,500, or $33,500.

An employer match reduces the gap—but there's still room for more DC contributions

Graphic shows how the employer match in the example closes the gap, leaving $33,500 available for additional DC contributions
This is a hypothetical mathematical illustration only. Figures are based on assumptions as set out, and individual circumstances may vary.

Now assume that the participant wants to contribute another $10,000, and the plan offers a mega backdoor Roth 401(k) feature. The participant can make the additional contribution on an after-tax basis, and then convert their after-tax contributions, plus any earnings, to a Roth 401(k) plan account. If they’d earned 2% prior to converting, for example, they’d pay approximately $30 in taxes on the earnings at the time of conversion. All future withdrawals from their Roth 401(k) account would be tax free.

And of course, participants over age 50 can contribute an additional $6,500 in catch-up contributions, for a total of $64,500.

The mega backdoor Roth helps close the gap

Graphic shows that the participant can do a megabackdoor Roth and pay income tax on the conversion, allowing the contributions to grow tax free
This is a hypothetical mathematical illustration only. Figures are based on assumptions as set out, and individual circumstances may vary.

Roth 401(k) qualified distribution rules

To qualify for special Roth tax treatment at withdrawal, participants have to satisfy two criteria: 

  1. At the time of withdrawal (distribution), Roth funds must meet a five-year holding requirement.1
  2. Participants must not take a distribution prior to age 59½, death, or disability.

Mega backdoor Roth 401(k) and discrimination testing 

After-tax contributions, along with any matching contributions, are included in a plan’s actual contribution percentage (ACP) test. So, offering a mega backdoor Roth feature may make it more difficult for your plan to pass the ACP test if mostly highly compensated employees (HCEs) make after-tax contributions. And if your plan fails the ACP test, after-tax contributions and earnings must be returned to certain HCEs.

So, before adopting a mega backdoor Roth 401(k), your plan consultant should perform projected testing to get an estimate of the maximum after-tax contributions allowed before a plan fails ACP testing. Depending on the results, it may be advisable to cap contributions in the first year.

Consider a mega backdoor Roth 401(k) to help retirement readiness

The IRS limits how much 401(k) participants can save, and nondiscrimination requirements may impose further caps. For some, these constraints make achieving retirement readiness harder. 

A mega backdoor Roth 401(k) allows participants to put potentially thousands more dollars into their 401(k) plan—and qualify for tax-free withdrawals. Consider speaking with a financial or benefits professional about how a mega backdoor Roth 401(k) can help your employees optimize the tax treatment of their retirement savings. 

 

1 Qualified distribution from a Roth account (including the five-year rule)—A qualified distribution from a designated Roth account in the plan is a payment made after the participant attains age 59½ (or after death or disability) and after the designated Roth account in the plan has been established for at least five years. In general, in applying the five-year rule, count from January 1 of the year the first contribution was made to the designated Roth account. Participants should contact their plan consultant or financial or tax professional for specific details on the five-year rule and whether any special rule may apply.

In this document, all tax disclosures regarding Roth 401(k) contributions are limited to the federal income-tax code and, in particular, all references to tax-free treatment of qualified distributions are intended to refer to the treatment of such distributions at the federal level only.

The content of this document is for general information only and is believed to be accurate and reliable as of the posting date, but may be subject to change. It is not intended to provide investment, tax, plan design, or legal advice (unless otherwise indicated). Please consult your own independent advisor as to any investment, tax, or legal statements made herein.

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