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By Ian Berger, JD
IRA Analyst

For a number of years, the “mega backdoor Roth” strategy has been touted as a way for employees to convert large amounts of after-tax employee contributions to Roth IRAs. Unfortunately, in most cases the strategy won’t work. Here’s why.

First, a little background. The mega backdoor Roth is simply the company retirement plan version of the backdoor Roth IRA. The backdoor Roth IRA is designed for individuals whose income exceeds the IRS limit for making Roth IRA contributions directly. The backdoor strategy allows for higher income employees to make Roth contributions indirectly by making a traditional IRA contribution and subsequently converting it to a Roth IRA. Congress and the IRS have both specifically blessed the backdoor Roth strategy.

By contrast, the mega backdoor allows 401(k) [or 403(b)] after-tax monies to be distributed while the employees is still working and immediately converted to a Roth IRA on a virtually tax-free basis. Why is this advantageous? Well, after-tax contributions and Roth contributions are both made with after-tax salary. But the earnings on after-tax contributions are taxable, while Roth IRA distributions are tax-free if made in a qualified distribution.

The mega backdoor is potentially even more lucrative than the backdoor. That’s because the backdoor Roth IRA is limited to the amount of traditional IRA contributions that can be made each year ($6,000 for 2020 with a $1,000 catch-up). On the other hand, annual after-tax contributions can potentially be considerably higher than that – as high as $30,000 or even more depending on the terms of the 401(k) or 403(b) plan.

But before you get too excited, be aware that the mega backdoor Roth works in only very limited situations.

First, the plan must allow after-tax contributions. 401(k) or 403(b) plan sponsors are not required to offer after-tax contributions, and many don’t. That is especially the case recently when more and more plans are offering Roth contributions instead. Second, an individual wanting to take advantage of the mega backdoor strategy must have enough income to make large amounts of after-tax contributions. Third, the plan must allow for distributions of after-tax contributions while the employee is still working. Even if a plan offers after-tax contributions, it’s not required to allow in-service distributions.

But the biggest problem is that IRS nondiscrimination rules limit the amount of after-tax contributions that high-paid employees can make based on the amount made by lower-paid employees. (See the November 13, 2019 Slott Report for more details.) Since high-paid employees are often the only participants able to afford after-tax contributions, it is difficult for plans to pass the nondiscrimination test. That’s why many plans don’t offer after-tax contributions in the first place.

One kind of plan where the mega backdoor Roth strategy would work is in a solo 401(k) plan. A solo 401(k) is a plan for self-employed persons with no employees (other than the spouse). Solo 401(k)’s are not subject to IRS nondiscrimination rules.

https://www.irahelp.com/slottreport/mega-backdoor-roth-usually-too-good-be-true