As we approach the end of the calendar year, you may see online articles encouraging both plan participants and Plan Sponsors to make Mega Backdoor Roth contributions.
While luring people in with enticing dollar figures and the promise of tax-free withdrawals, these articles tend to overlook critical factors that affect how much participants are actually able to contribute.
Strategizing with a mega backdoor Roth 401(k) allows participants to save more by combining after-tax contributions with a Roth 401(k) that permits after-tax Roth conversions. The number of conversions allowed each year is determined by the Plan Sponsor.
For 2024, the IRS caps employee pretax 401(k) contributions at $23,000 and contributions from all sources (pretax, after tax, and employer) at $69,000. The difference between the two limits, $46,000, is a gap that some employees, especially those with higher incomes, may want to take advantage of.
While employer contributions can help bridge this gap, mega backdoor Roth 401(k)s can be a tax-friendly tool to help your employees save more. If allowed by the plan, after-tax contributions enable participants to save more in their 401(k), with a limit of up to $69,000.
Even if a plan permits after-tax contributions, however, keep in mind that it may not always make sense for a participant to use them. The earnings on after-tax contributions are taxed as regular income upon distribution, whereas gains in a taxable brokerage account may be taxed at a lower capital gains rate.
When you offer both savings options, participants can take full advantage of the $69,000 annual addition limit in 2024 and close the 401(k) savings gap by:
*Future earnings are tax free, if the participant meets Roth distribution rules.
Here is an example of how a mega backdoor Roth can help you save more and minimize future taxes:
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.
Now let’s assume you want to contribute another $10,000, and the plan offers both a Roth 401(k) feature and an after-tax feature. You can make the additional contribution on an after-tax basis and then convert the after-tax contributions, plus any earnings, to a Roth 401(k) plan account.
If you had earned 2% prior to converting, for example, you would pay approximately $30 in taxes on the earnings at the time of conversion. All future withdrawals from your Roth 401(k) account would be tax free.
And of course, if you are over age 50, you can contribute an additional $7,500 in catch-up contributions, for a total of $65,500. The mega backdoor Roth helps close the gap.
To qualify for special Roth tax treatment at withdrawal, participants have to satisfy two criteria:
After-tax contributions, along with any employer matching contributions, are included in a plan’s actual contribution percentage (ACP) test. This test measures the average percentage of matching contributions (plus after-tax contributions) between the highly paid employees versus those non-highly paid employees.
If the averages fall outside of the required limits, the test fails and refunds, plus earnings, must be given back to some of the highly paid employees. 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.
Before adopting a mega backdoor Roth 401(k), you should speak with your plan consultant to determine if this strategy would be a good fit for your plan.
Plans where it would be a good fit:
Plans where it would not be a good fit:
This website uses cookies. By accepting the use of cookies, this message will close and you will receive the optimal website experience. For more information on our cookie policy, please visit our Privacy Policy.
