In Saturday’s Wall Street Journal, an article appeared on a strategy known as the mega-backdoor Roth conversion. We all know that contributions to a Roth account are made with after-tax dollars and that the earnings grow on a tax free basis. The article referenced one Peter Thiel, whose pre-IPO Roth account has grown over the course of two decades to $5 billion dollars. Having a tax free account (and presumably still growing!) of $5 billion dollars sounds pretty good to me.
Of course, most of us will never have the opportunity to own pre-IPO stock. But investing in a Roth account can be a very effective retirement strategy. On top of choosing to designate your salary deferrals to go into an after tax Roth account, the article highlights a strategy known as the mega-backdoor Roth conversion strategy. The questions are, how does it work and can it work for you?
First, we need a bit of background. The current salary deferral limit to any 401(k) plan is $19,500. If you are older than age 50, you get to defer an additional catch-up contribution of $6,500, bringing the total maximum deferral to $26,000. Leaving the catch up alone for a moment, the maximum that any individual can get into their account in a calendar year from salary deferrals, forfeitures and employer contributions (be they matching contributions or profit-sharing contributions) is $58,000. So let’s say that someone defers the maximum $19,500 and received a company match of $2,500. That leaves (theoretically at least) another $36,000 ($58,000 – [$19,500 + $2,500]) that could go into their account. Can this $36,000 be the mega-backdoor Roth conversion strategy that the article referred to? Let’s see:
According to the article, you would do the following:
- While the article does not specifically call it this, you, the participant, would make an after tax voluntary contribution of $36,000.
- As soon as possible, before it can accrue any earnings roll it out to a Roth IRA (or keep it in the 401(k) plan in a Roth bucket).
So there you have it, you have just completed the mega-backdoor Roth conversion strategy.
So apparently, anyone who has the means should be taking advantage of this strategy, right? Well, not so fast. There are a couple of barriers that we must clear.
First of all, the plan needs language within it to accept after tax voluntary contributions. Most plans do not currently contain that language. But certainly, an amendment can be done to allow for the plan to accept after tax voluntary contributions. That is easy to accomplish. So we can easily clear that barrier.
The next barrier is more problematic. Who is most likely to be in a position to make after tax voluntary contributions? The Highly Compensated Employees (HCEs), which is a defined term in the Internal Revenue Code. Just like there is a discrimination test that a 401(k) plan must pass on the employees’ salary deferrals, known as the Actual Deferral Percentage (or ADP) test, so must an employer’s matching contribution pass its own discrimination test, called the Actual Contribution Percentage (or ACP) test.
In both tests, you divide the plan participants up into two groups: HCEs and NHCEs (if you are not an HCE then by default you are an NHCE). Following certain rules, in both the salary deferral (the ADP) test and the employer matching contribution (the ACP) test, the amount that the HCEs can defer or receive as a company match must satisfy certain discrimination tests. In each case, the amount that the HCEs can defer or receive as a company matching contribution, is a function of how much the NHCEs defers or receives. Remember that anything times nothing is nothing.
The IRS has designated that after tax voluntary contributions are to be treated as if they were company matching contribution, even though the after tax voluntary contribution was made by an individual participant and not by the plan sponsor. So if the only group that makes after tax voluntary contributions is the HCE group, then you will almost certainly fail the ACP test. As a result, the after tax voluntary contribution would then get refunded to the individual who made it, plus any earnings the after tax voluntary contribution made while it was in the plan. You would need to pay income taxes on those refunded earnings.
The mega-backdoor Roth conversion strategy may work in certain larger companies that have many HCEs on their payroll. It definitely works in plans that do not have NHCEs in them (plans where only owners and/or HCEs are in the plan). In that case, there are no NHCEs to test against so you pass by default.
But will it work as a strategy for most of the retirement plans that we see that have a mixture of HCEs and NHCEs in the plan? Almost certainly not.
Based upon a July 9th, 2021 article by Anne Tergesen in the Wall Street Journal