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The Mega-Backdoor Roth IRA: What’s the Real Story Behind this Retirement Wealth Strategy?

A recent Wall Street Journal article spotlighted the $5 billion Roth IRA fortune of Peter Thiel, co-founder of PayPal. Mr. Thiel made a pre-IPO investment in his company (buying shares at fractions of a penny) and contributed $2000 to his Roth IRA in 1999. He never made another contribution to the plan. Proceeds from gains of his high-growth assets were used to make other investments (which are tax free within a Roth IRA). Over the years, the plan’s value grew to $5 billion as what is now called a mega Roth or mega-backdoor Roth IRA.

The article described this mega-backdoor Roth as a “little known trick,” but the strategy is not new. It’s a way for investors to accumulate more retirement savings through a Roth conversion—rolling over funds from a Traditional IRA or a qualified retirement plan into a Roth IRA or the Roth “bucket” in an employer-sponsored plan. This transfer is the workaround to the income limits for contributions to move funds into these tax-free accounts (since contributions to a Roth IRA are tax free upon distribution).

How the mega Roth IRA works with a 401(k) plan

Participants in a company’s 401(k) plan elect employee salary deferrals, which can be up to either $19,500 or $26,000 for workers ages 50 and up; there are also potential employer contributions. Taken together, the maximum annual contribution limit (between employee deferrals and employer match contributions) is $58,000 (or $64,500 for those age 50+).
The “back door” is when the participant makes an extra non-deductible, after-tax voluntary contribution to the 401(k) plan (up to the maximum annual limit of $58,000 or $64,500) and then moves that amount over to the Roth IRA or keeps it in the plan’s Roth account. Over time, this individual can build a mega Roth.

Who benefits most?

“We’re seeing a lot of interest in this among sole proprietors with no employees, who are seeking ways to preserve their wealth from future tax liabilities,” said Charles Rosenberg, vice president of INTAC. “This strategy also works well for small businesses comprised of all highly compensated employees because no discrimination testing is needed in these scenarios.”

Notes of caution

  • The plan design must include the language and provisions that enable participants to execute this strategy. If not, an amendment must be done.
  • The mega Roth strategy may cause discrimination testing issues for plan sponsors. Here’s why:
    • Participants are divided into highly compensated employees (HCEs) and non-highly compensated employees (NHCEs). The amount that the HCEs can defer or receive as a company match must satisfy certain discrimination tests; this amount is a function of how much the NHCEs defer or receive.
    • The employer’s matching contribution must pass the Actual Contribution Percentage (ACP) test.
    • The 401(k) plan must pass the Actual Deferral Percentage (ADP) test for employees’ salary deferrals.
  • The IRS has designated after-tax voluntary contributions—made by the individual participant and NOT the employer—to be treated as if they were matching contributions. Since it is highly probable that the only HCEs are making those voluntary contributions, the plan will almost certainly fail the ACP test. 
    • If that happens, the after-tax voluntary contribution is refunded to the individual along with any earnings the contribution made while it was in the plan. There is an income tax liability on those refunded earnings. 
    • Larger companies with many HCEs on the payroll may be able to pass this testing if only some of these employees make these contributions.  

NOTE: Roth transfers and conversions generate a 1099-R taxable event (for earnings on the after-tax contributions), so participants should be aware of this. Plan sponsors and participants are wise to be cautious, and should discuss the mega Roth strategy with their trusted plan administrators, tax planners, or financial advisors before implementing this.

Cash balance plans as an alternative

Income eligibility criteria knock many high-income earners (who are not sole proprietors) out of the Roth IRA arena, and in-plan conversions trigger tax events. However, employers can implement a cash balance plan to help mitigate some of the tax consequences that result from the transfer of pre-tax assets to a Roth IRA.

As always, our INTAC plan consultants are available to review your current plan design, share their expertise about qualified retirement plans, and discuss how a cash balance plan can help plan sponsors and participants reach their goals.

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