[Editor's Note: Today's guest post is from Konstantin Litovsky, a long-time WCI partner and an expert in designing low-cost small practice retirement plans.]
Much of the information available on the internet and on WCI covers individual or ‘solo’ 401(k) plans. Not a lot is written about Employee Retirement Income Security Act (ERISA) 401(k) plans where in addition to owners (who are highly compensated employees, or HCEs) there are also non-highly compensated employees (NHCEs). Most plans that are not owner-run, such as those offered by hospitals, universities, and other large employers don't allow the option for doing Mega Backdoor Roth conversions, but a smaller partner-run practice plan can easily adopt any changes necessary to implement the mega backdoor Roth 401(k) strategy.
ERISA vs. Non-ERISA 401(k)
ERISA 401(k) plans are covered under ERISA (Federal law) and while individual 401(k) plans are not covered under ERISA, they are still covered under both Federal and State law. There are several key differences between ERISA and non-ERISA 401(k) plans:
- Protection for bankruptcy vs. creditors. ERISA assets are protected up to an unlimited amount from both bankruptcy and creditors. Individual 401(k) plans offer bankruptcy protection and will offer some protection from creditors depending on the State law.
- ERISA plans come with an additional compliance burden vs. individual 401(k) plans. As a result, there are some nuances when implementing mega backdoor Roth with ERISA plans.
- The biggest difference as it relates to mega backdoor Roth is that individual plans can be set up as needed for optimal mega backdoor Roth, while ERISA plans cannot always be customized for mega backdoor Roth due to plan design and demographics.
In this article, we’ll discuss how ERISA plans can implement mega backdoor Roth 401(k), as well as why mega backdoor Roth works for high-income doctors, and what some of the reasons are to consider it.
Why Roth IRA?
Roth IRA distribution is not taxable under current tax rules, and this is unlikely to change in the future. Roth allows tax-free accumulation and withdrawals, which is especially valuable for high-earning doctors due to the uncertainty related to future tax laws and the real possibility that taxes will be increased over time. Because many WCI readers are in the top 1%, much of the conventional wisdom does not apply to them, so we need to develop a set of guidelines that can help those in the highest tax brackets make informed decisions regarding different retirement plan buckets, especially Roth.
#1 Retirement Tax Bracket Considerations
It is generally agreed that if you are in the highest tax brackets during your working years and expect to be in lower brackets in retirement, that the tax-deferred bucket is the most important one to maximize vs. Roth. This is because Roth presents a significant tax drag paid at a high average tax rate, which will eventually add up to the point where tax-deferred is a better long-term account vs. Roth. For those in the highest brackets, non-deductible Traditional IRA to Roth IRA conversion, or the ‘backdoor’ Roth, is a very popular option due to having no tax drag, albeit adding up to a relatively small amount.
There may be situations when your tax brackets will be the same or higher in retirement, and, in that case, maximizing Roth can be a good idea. This is not easy to forecast, so some degree of tax diversification will be advisable. For example, a Cash Balance plan might not seem very useful from a Roth standpoint, yet it is a good way to put a lot of money into a tax-deferred account that can be converted to Roth later on when you are in the lower tax brackets. We’ll discuss this in more detail below. Making bigger Roth contributions into a 401(k) plan might also work if you already have access to other accounts where you can get a tax deduction on your contributions (such as a Cash Balance plan, for example), and you can consider this as a form of tax diversification in case you don’t end up in a lower tax bracket in retirement.
#2 Required Minimum Distribution Planning Considerations
Even though these types of calculations can be quite involved and highly dependent on individual tax situations (as well as on multiple assumptions), in general we can say that those with a large tax-deferred portfolio ($3M and above) should rightly be concerned about RMD (required minimum distribution) taxes. RMDs start at 4% at age 72 and go up to as high as 11% at age 95. The big question is whether taking RMDs is better than the alternative, which is converting some or all of your tax-deferred portfolio to Roth. With Roth, your distributions are tax-free (and can be withdrawn 5 years after conversion), so what we need to determine is whether it is worth prepaying taxes to end up with a big Roth account or whether it is better to take RMDs and do nothing.
As an example, let’s consider someone who is retired at age 62 with a $5M tax-deferred portfolio, which is not that difficult to accumulate if you’ve participated in a 401(k) and a Cash Balance plan over the course of your career. Let’s assume that all of the taxes will be paid from a taxable account, that conversions are done over a 10-year period from age 62 to age 72, and that the life expectancy is age 95 (which is not unreasonable since the surviving spouse can carry on the Roth conversion strategy without interruptions). Let’s also assume that from age 62 to 95 we have a 4% return for the taxable account, 6% return for Traditional IRA/Roth IRA accounts, 2% inflation, and that all tax-deferred accounts will be converted to Roth at the end of the 10-year period. To cover expenses, $100k will be withdrawn from the taxable account each year, and Social Security of $34K for each spouse would be taken at age 70.
According to this retirement plan calculator offered by Wealth Trace, the net advantage of the Roth conversion strategy (from age 62 to age 95) is about $4.5M vs. taking RMDs and not doing any conversions. The average tax rates (from age 62 to age 95) are 20% and 15% respectively for the RMD and the Roth conversion strategy. Even though during the 10 years when conversions are made the tax rates are higher, they are much lower during subsequent years. On the other hand, RMD tax rates are much higher from age 85 to age 95. You are also going to pay about $2M in taxes during the 10-year conversion period, so this approach will require a sizeable taxable portfolio. Please note that the numbers can vary widely depending on retirement age, conversion period, starting portfolio, return assumptions, etc., so this example should not be used as a general rule, but rather as a starting point to discuss this strategy.
What happens if neither of the spouses lives to age 95? There is a breakeven point which would vary depending on all of the assumptions mentioned above, and it is likely to be in the early to middle 80s for most scenarios. Whether the breakeven point is reached or not, there is another important reason to consider Roth conversions in retirement.
#3 Estate Planning Considerations
Konstantin Litovsky
The SECURE Act of 2019 eliminated the ‘stretch’ IRA, which was a key estate planning component for those with high tax-deferred portfolios, removing the ability to distribute IRA assets over the lifetime of IRA beneficiaries. Instead, IRA assets are now going to be distributed over 10 years, which can create a significant tax burden for the beneficiaries. Imagine a $5M IRA distributed over 10 years by a single beneficiary (non-spouse and non-minor). Each year as much as $500K has to be removed, catapulting the beneficiary into the 35% bracket. Moreover, if we assume a modest 4% return, this amount jumps to about $600K, and this will most likely put the beneficiary into the highest Federal and State brackets. In some states this can be as high as 50%, resulting in as much as 1/3 of this money disappearing due to taxes.
This might result in as much as $2M in taxes on $6M withdrawn over 10 years. As you can see, even if the IRA owner just breaks even on the conversion, they will give their beneficiary an additional $2M if instead of distributing a Traditional IRA over 10 years the beneficiary can distribute a Roth IRA.
Three Ways to Accumulate Roth Assets
Now that we’ve discussed several planning strategies using Roth, let’s talk about ways to build up a big Roth account during the accumulation phase if you don’t have access to an individual 401(k) plan. For the discussion below, it is assumed that the practice owners control the plan document and that appropriate amendments can be made to the plan document to allow in-plan Roth conversions, depending on the specific needs and demographics of the plan.
#1 Backdoor Roth IRA
This is the default approach for anyone who is phased out from contributing to Roth IRA directly. A non-deductible Traditional IRA contribution is made and converted to Roth immediately.
#2 Mega Backdoor Roth 401(k) – Version 1
Version one of the mega backdoor Roth 401(k) involves in-plan Roth conversion of after-tax voluntary employee contributions that can be made into a 401(k) plan. After-tax contribution can be converted to Roth inside the plan without having to move the money out (usually as soon as the contribution has been made). No tax is owed on this transaction. Total contribution can be made up to $58K in 2021 (maximum total contribution, employee and employer), and this is usually made as Roth 401(k) ($19,500) plus Safe Harbor (4% match or 3% non-elective contribution which is tax-deferred) and after-tax contribution (up to the maximum). While in principle it is possible to roll just the after-tax money out of the plan into a Roth IRA before reaching age 59 and ½ as an in-service distribution, you need to be careful because the IRS requires that money is rolled over pro-rata, so if there are any gains on after-tax contributions, these would have to be rolled over as well (and since the gains on after-tax contributions are taxable, the gains can be rolled to a Roth IRA, but you will need to pay all applicable taxes on this transaction). Moreover, your plan document has to specifically allow in-service distribution of after-tax money, so this can be a viable option if all of the rules are followed closely. If you’ve already converted after-tax to Roth inside the plan and you want to roll the converted amount to a Roth IRA, this can also be done as an in-service distribution. One important thing to note is that taxable gains converted to Roth inside the plan and gains accumulated after the conversion to Roth inside the plan are subject to the ‘5-year’ and ‘age 59 and ½’ rules once rolled over to a Roth IRA (one has to wait 5 years and be 59 and ½ to withdraw the gains, while the basis can be withdrawn immediately).
#3 Mega Backdoor Roth 401(k) – Version 2
Version two of the mega backdoor Roth 401(k) involves in-plan Roth conversions of tax-deferred assets. Tax-deductible contributions to your 401(k) can be converted to Roth inside the plan (you specify the amount and timing). This can allow you to make strategic Roth conversions on demand. For example, when the market crashes, you can convert part of your portfolio to Roth at a discount. Conversion is made pro-rata—equal percentages are taken from all of your plan investments. In the version one plan, Safe Harbor match/contribution can be converted to Roth as well.
A note about converting both after-tax and tax-deferred assets to Roth. Some record-keepers (including Ascensus) can only track one source of Roth conversion, so if more than one source is used (including both after-tax and tax-deferred), the third-party administrator (TPA) has to make sure that this is tracked accurately.
Partner Only (HCEs) vs. Partners and Staff (NHCE)
ERISA Plans with Partners and NHCE Staff
In the case of an ERISA plan with NHCE staff, after-tax is rarely if ever going to work unless your NHCE staff is making after-tax contributions, which they have no reason to make. This is because after-tax contributions have to pass the Actual Contribution Percentage (ACP) test that compares how much NHCEs are contributing vs. the HCEs, and if not enough NHCEs are contributing, then HCE contributions would be refunded (defeating the whole purpose for making them). As a result, solo and group practice plans with NHCEs can only do in-plan Roth conversions.
In-plan Roth conversions of tax-deferred contributions will produce exactly the same Roth account as when making Roth conversion of after-tax contributions. The only time this makes a difference is when you also have eligible qualified business income (QBI) that you want to maximize, in which case making after-tax contributions is preferable as that would preserve your QBI deduction. However, this only applies to businesses that get an unlimited QBI deduction regardless of income (known as ‘qualified’) vs. ‘specified’ businesses (including medical/dental) that are completely phased out after owner’s or partner’s taxable income on joint return reaches $421K (in 2021). For this reason, QBI is not an option for most partner-only group medical practices that will consider making after-tax contributions.
ERISA Plans with Partners Only
If your plan has only owners/partners and no NHCE staff, you can make after-tax contributions, and consequently make Roth conversions of both tax-deferred and after-tax contributions. One use of after-tax contributions would be in a 401(k) with a non-PBGC Cash Balance plan (with fewer than 25 participants) where profit sharing is limited to 6%. In this case, you can potentially contribute up to the maximum allowed ($58K in 2021) into the 401(k) using after-tax contributions, and convert those to Roth.
This can sometimes get tricky with partner-track doctors who are allowed to enter the plan immediately since they enter the plan as NHCEs during the first year (even if they make above HCE salary limit since day one). They are usually given a top-heavy minimum employer contribution (3% Safe Harbor contribution if there is only a 401(k), and additional 2% profit sharing if there are both 401(k) and CB plans), and if the doctor is not an HCE the following year (because they only worked part of the year and haven’t reached HCE maximum), they would have to be given an additional profit-sharing contribution.
In order for partners to make after-tax contributions themselves, partner-track doctors should make after-tax contributions as well, as discussed above (and usually they would be willing to do so). In the case of the top-heavy minimum, this calculation is rather straightforward (basically, making sure that together with the salary deferral and employer contribution, the after-tax contribution does not exceed the maximum allowed into the plan). However, in the case of NHCE doctors, the issue is that they do not know exactly what their employer contribution will be (as it is usually calculated the following year by the TPA), and in some cases it would be quite high, so this won’t leave much room for after-tax contributions, at least as long as they are NHCEs. Due to this issue, after-tax contributions have to be carefully planned especially if you have immediate eligibility for partner-track doctors.
References
After-tax in-service distribution rules
IRA distribution rules
More on ERISA retirement plans
More on Cash Balance plans
Have you used an ERISA plan in your small practice? Why or why not? What has your experience been? Comment below!
Regarding :
“According to this retirement plan calculator offered by Wealth Trace, the net advantage of the Roth conversion strategy (from age 62 to age 95) is about $4.5M vs. taking RMDs and not doing any conversions. “. Can you please provide a visual of what this looks like in a table, year by year of the effect of converting the Roth, paying taxes, etc. so that at the end of age 95 there is this 4.5m net that you mention. I imagine the net column will initially be negative and then it swaps over from negative to positive in the early 80’s age range. Thanks for considering. The “link” is great but a table provides the transparency to see “behind the curtain” of what is actually happening on a year by year basis.
Hi Paul,
That’s a good point. I did not receive permission from Wealthtrace to use their data for an article, so unfortunately I can not include the visual. You can sign up for a free evaluation of the software and try to run a scenario yourself, which would be quite instructive as well. It only takes several clicks to get a scenario going (I basically assume one is at retirement with the final portfolio amounts to simplify the analysis), and I would encourage that you put in your own numbers, as based on my analysis it is best to evaluate each individual situation separately. I would also not anchor on a specific number, my main point is that doing Roth conversions in retirement can have a big advantage vs. not (and that for larger portfolios you can potentially get higher savings). I would also have preferred to do a ‘Monte Carlo’ type analysis where I can plot curves for various parameters (not possible with this software), since a single run is not very useful for planning purposes because small changes in inputs can result in large changes in the output.
I might one day write an article just on the analysis of Roth conversion scenarios, but only if I get access to good software that allows Monte Carlo type analysis which is in my opinion the very minimum needed to understand how various parameters impact one’s decisions. However, for individual purposes, having a single run (or a set of runs) is probably fine if you run several scenarios (such as minimum/maximum for a set of parameters to understand what your range is). Ideally, if you are working with an adviser, they should be the ones helping you with the planning, as for some docs this might be too much, however I would still encourage you to play with the numbers just to get a sense of how complex this issue can be. This is one big reason why I didn’t want to get into the details of an actual Roth conversion example, as it wasn’t the purpose of the article.
There is another software I’m currently evaluating, and here are two videos on optimal Roth conversions by the software designer (Larry Russell) that might have what you are looking for:
https://www.youtube.com/watch?v=PaYC7MnX_9U
https://www.youtube.com/watch?v=Ij890zUr1OA
This is the software:
https://www.theskilledinvestor.com/VeriPlan/
Definitely give it a try if you want to play with the numbers (I believe it is something like $50). It is quite involved though, so only get it if you want to spend time understanding how it works.
Via email:
Great information here. I work for an RIA and love the blog. It’s a great refresh for things I might not have had to do planning on recently. I wanted to make a note about the end of the “#2 Mega Backdoor Roth 401(k) – Version 1” section. Conversion to a Roth from a tax deferred account have their own 5 year rule on each conversion. This is on principle and earnings that are converted. This keeps folks from converting their IRA early just to avoid the 10% penalty. I think that’s what is being said at the end of the section but just wanted to make sure. The way I read it in the article sounded like conversions wouldn’t be penalized ever.
Super thankful for you all!! You are doing great things to move personal finance and investing forward!
Version 1 is talking about conversion of after tax to Roth, not tax deferred, and 5 year rule does not apply to converting after-tax money to Roth inside the plan. The 5 year rule applies only to tax-deferred growth of the after-tax money.
Yes, of course 5 year rule applies to tax-deferred to Roth conversions.
“… Social Security of $34K for each spouse would be taken at age 70”.
The maximum SS benefit in 2021 for someone filing at age 70 is almost $47K.
That is true, I probably used default numbers. SS is not going to be as important for those with $10M+ portfolio, and some docs might be working full time at age 70, so for them the numbers will be quite a bit different. This is why everyone should be using their own individual numbers. This is a very complicated problem and I didn’t even attempt to set up a typical or average scenario, just a scenario with large numbers to show that doing the conversion can be a key decision for those with $10M+ portfolios.
Not everyone gets the maximum. It’s probably a reasonable assumption.
Yes, the assumption was that someone with a $10M portfolio should be getting the maximum. Technically, it should be higher than $34k, probably close to $42k, if their income was $200k+ on average, so OP is correct that it should have been higher. However, the spouse may not have gotten much if they didn’t work or worked very little, even on practice payroll, so 2x$34k probably covers most scenarios.
Depends on how they got to that $10M. If they got there quickly, they may only have 10-20 years of SS contributions and not get anywhere near the SS max.
At any rate, I agree it’s a reasonable assumption and if people want better numbers, they need to use their own.
Thanks for the information-filled article.
Could you help clarify a concern I have about 401k testing? My 401k administrator has assured me that I am able to make after-tax contributions… but your article states I shouldn’t be able to do. Our safe harbor plan includes about a dozens employees. Could it be that my 401k administrator has made a mistake with testing? Or is there another explanation?
And if it is a mistake on his part, what risk am I carrying?
If rank and file does not make after-tax contributions, it is quite simple – you don’t get to make any either. If the ACP test has failed, you simply get the money back like you’ve never contributed, or rank and file has to be given appropriate employer contribution. And this has to be done within 12 months. If you’ve already made after-tax contribution and converted it to Roth, this has to be undone (and I’m not sure what exactly has to be done in that case, it can get complicated depending on what exactly was done – you can’t just return ‘Roth’ money via a check, but can you move it to Roth IRA instead? That would be nice, but I don’t know if that’s possible). Maybe clarify this in more detail with your administrator. Ask about the testing and how making after-tax contribution will pass testing (and if not, what are the consequences). If the person you are talking to is just a rep, see if you can get to talk to an actual TPA, maybe that’s where the disconnect is.
I have the opportunity to join a small practice with a currently solo physician who does not give any benefits to the employees (an NP, a PA, and 3 administrative staff). He recommends I incorporate myself and set up my own retirement plan. Can I set up a solo 401K where I can do mega Backdoor Roth for myself and not have to set up anything for the employees there?
Thanks!
If you join as a W2 employee, you can not do that. If you join as a partner – same thing, the plan would have to be set up at the partnership level. The only way this is possible is if you are a 1099.
If you’re an employee or partner, no. If you’re an independent contractor, yes. The incorporation doesn’t change anything; that’s bad advice.
As with anything in life after med school, I’m getting a late start on personal and family finance. Thank you for this website! I recently learned that my work 401k with Fidelity offers the option for after-tax contribution and according to Fidelity there is the option of auto conversion to a Roth (I’m assuming an in-plan conversion and not rolled over into a Roth IRA, but need to clarify with Fidelity). For whatever reason my work only makes after-tax funds available the following year in Spring. I’m concerned about earnings throughout the year triggering taxes, more so as it would affect my back door Roth with Vanguard (thank you again @WCI). Are these valid concerns, or at most just a few hundred dollars in tax on earnings going into the Roth? Thanks all.
I’m not sure what you mean by ‘makes after-tax funds available the following year in Spring’, After-tax is a voluntary employee contribution, and you make it usually once a year, and immediately convert to Roth. This wouldn’t affect backdoor Roth outside of the plan, but any earnings on after-tax would be taxable. Definitely discuss with them about the process. Having some accumulated earnings is not an issue at all (you just convert the principal), but having to wait to convert this long doesn’t sound right unless I’m missing something.
Thank you. I agree, it doesn’t make sense when I talked with HR, but that’s verbatim what they told me: they “double check the finances, and make the after tax funds available in Spring of the following year.” Definitely need to talk with both Fidelity and HR again.
Ask them about the process, what is involved, etc, I would guess from the language that they probably are running tests to see if after-tax contribution by HCEs passes the IRS testing, and if so, how much after-tax can be contributed per participant. Maybe that’s what they are talking about. This also corresponds to the usual timing of plan valuations (Spring). If not enough NHCEs are making after-tax contributions, what happens to HCEs is they get their entire contribution refunded. That’s not where you want to be. However, deadline for making after-tax contributions is Dec. 31st, so do they have you make the contribution by Dec. 31st, then do the valuations, and THEN they throw the money back to you (or let you keep it inside the plan)? This sounds like what’s happening, so they don’t let you convert until they go through the whole process. If so, this is a giant mess, but it sounds like that’s what they are doing. I guess you can try making after-tax contributions, but do ask them how much of that would stick (if any) based on past history, and how much of that was returned to HCEs in the past.
You’re going to pay the taxes anyway, what’s the big deal? You have to pay both income and payroll taxes on all the money. All you’re losing by having to wait to do this is the taxes on the potential earnings you would have from getting the money in earlier.
As far as “the next year” this is no different from many “self-matches” that self-employed partners do. I just barely ironed out what my 2020 401(k) match should be this month. It turns out the plan didn’t allow me to put in as much as the IRS allows (which is what I put in in April), so they’re taking my overcontribution and relabeling it a 2021 matching contribution.
The issue is that they might return the entire amount back to OP after holding it for nearly a year because the plan failed testing. Pretty annoying, the money is just spit out, I’m not sure how they deal with the gains in that situation. It would probably still be a good idea to contribute regardless, but that’s the potential downside.
No, it sounds like he doesn’t have to write the check until the next year, no?
Employee contributions have to be made by Dec. 31st at the latest (unless you are K1 or 1099), and after-tax is an employee contribution. So the way I understand it, they make the contribution, and can’t convert until the plan says that their contribution is accepted (which happens in Spring). That’s the only way I can interpret the delay in letting them convert to Roth. Hopefully OP gets a clarification on this, but this is the most logical way to interpret the facts presented so far.
Thanks @Kon and @WCI. @Kon this sounds exactly like what is going on—thank you for helping me to understand it. Money is deducted throughout the year. Also strange, HR told me that I could contribute up to 6.6k in after tax, although when I talked to Fidelity, they said it should be 38.5k for the 401k (employee 19.5, no employer contribution to the 401k). HR says this is because of employer contributions to a separate 401a (no employee contributions there) bringing the total to 58k. Again, my understanding from reading and also in speaking with Fidelity is that a 401a and a 401k have separate 58k max contributions. Again, waiting to hear more from my HR.
If I remember correctly, 401a and 401k have the same total limit, so this might make sense if $6.6k is the difference.
Yes, 401a and 401k and 403b all share the same $58K per employer limit.
@WCI, thanks as well. I don’t know why this was so hard to find. And obviously so encouraging that the Fidelity person I spoke with didn’t know this. And thus I am here. Thanks again. Just leaves my TurboTax trepidation which I will get over if needed.
@Kon, thanks again. It’s been difficult to get the answer as most comment on 401a vs 403. And I completely agree with @WCI in terms of just doing the after tax contribution, I’m mostly just preparing myself for any TurboTax headache later if in regards to my initial concern with tax on earnings for the Roth rollover, would I report those on IRS Form 8606 when I do my backdoor Roth or would this would depend if the Roth rollover is in plan versus via an IRA rollover? Thanks again.
Fidelity will most likely send you all of the right tax forms for the in-plan rollover, so I wouldn’t worry about it. You might as well just convert everything and pay the tax on the gains (if any).
Thank you again!
If it never goes into an IRA it never shows up on Form 8606.
Got it! Thank you!
WCI,
“If it never goes into an IRA it never shows up on Form 8606”
So it seems like what you are saying is that if the 401k plan allows you to roll the after-tax portion to the Roth and the after-tax earnings to an IRA this will end up making you file form 8606 for the life of all your IRA funds.
The alternative seems to be pay the tax while it is within the bounds of the 401k and move both after-tax contribution and earnings to the Roth.
Is there any other option?
Just putting money in an IRA doesn’t require filing form 8606. As the 8606 instructions state:
https://www.irs.gov/instructions/i8606
Remember earnings on after-tax contributions to a 401(k) or traditional IRA are pre-tax.
I work for a large corporate (>50k employees) whose 401k has good investment options and allows Roth contributions, but doesn’t allow mega backdoor Roth contributions. Since I can only save $20.5k + the employer match in the 401k, I find myself making large contributions to a taxable account. I’m trying to convince my employer to change the plan to allow a mega backdoor Roth, but HR says ERISA non-discrimination rules prevent them from doing so. The company does have a lot of non-highly compensated employees, but I actually think that the company’s match would put it in the safe harbor. The employer contributes 3% (without requiring any employee contribution), then matches employee contributions 1:1 for the next 3%, then matches employee contributions at a 50% rate for the next 1.5%, for a total possible match of 7.5% if an employee is contributing at least 4.5% of his comp. Is HR mistaken, or are there other non-discriminations rules that prevent them from adding the mega backdoor Roth option?
The issue is that if HCEs use it more than NHCEs, this will become a problem as they would have to refund the contributions to HCEs. They probably mean that they have to do testing for this option, but there are no rules that prevent it from being implemented. Maybe they just don’t want to do it, and that’s the blanket answer (which doesn’t answer anything). If they knew ahead of time that they will fail testing, that’s one thing, otherwise they have no idea what participation is going to be like, and they probably just don’t want to deal with having to do another test and pay for it.
Thank you, that makes sense.
Is there any way to get into a safe harbor to avoid having to go through this test? A majority of my firm is NHCEs so I suspect without one the firm would fail the test. I thought the match in this case was high enough to get to a safe harbor.
Not allow any HCEs to participate? I don’t think there is a safe harbor for this, one can not avoid the test, it has to happen if this is an available option for the plan.
Non discrimination rules are pretty complicated, but you’re right that many companies CAN do more than they are actually WILLING to do and still be okay. I doubt you’re going to have much effect in changing the 401(k) at a company with 50K+ employees anyway unless you’re in the C-suite.
Sorry.
Thanks for the informative post, Kon. Regarding the scenario where money from the after-tax bucket of a 401k plan is being rolled over to a Roth IRA, I understand the pro-rata rule requires that the pre-tax amounts in the after-tax bucket (i.e. earnings on after-tax contributions) be rolled over in proportion to the after-tax amounts being rolled over.
Is it correct that the pre-tax amounts held in the traditional tax-deferred bucket of the same 401k plan do not need to be considered in the pro-rata calculation? I’ve read a few different articles suggesting that if the plan administrator tracks contributions and earnings on those contributions by contribution source, that the plan participant should be able to rollover money solely from the after-tax bucket, along with the associated pre-tax earnings, without touching the traditional tax deferred money. However, I don’t think I’ve seen someone confirm this to be the case with as much certainty as I would prefer.
This is an interesting question. I believe the whole idea behind this is that you are rolling over your 401k balance, and once you do that, you can just roll your after-tax to Roth, and tax-deferred to Traditional IRA. At least that’s how I understand the purpose of this rule. Some plans simply do not allow in-service distributions, so in that case it wouldn’t even be possible to do. That said, I’ve been told by an ERISA attorney that you can move after-tax money that has been converted to Roth inside the plan directly to a Roth IRA, so that’s probably your best option.
Here’s what another publication says about your question:
“My account in my employer’s retirement plan is made up of employer contributions, my after-tax employee contributions, and earnings on both. Can I take out just the after-tax portion and roll it to a Roth IRA and leave the rest in the plan?
No, you may not take a distribution of only your after-tax contributions. Any distribution from a retirement plan account in which there is basis is treated as consisting of both pre-tax amounts (your employer’s pretax contributions and earnings) and your after-tax contributions. The after-tax contribution portion of each distribution is tax-free, but the rest must be included in your gross income. To determine the amount of the distribution to include in your income, subtract the portion that represents your after-tax contributions. You can use the following formula:
Amount of Distribution x Your After-Tax Contributions = After-Tax Portion Your Account Balance
The total amount of the distribution minus your after-tax portion equals the amount that must be included in your gross income. If you roll over the distribution to a Roth IRA (assuming you meet the income limits and filing status for making rollovers to Roth IRAs), the pre-tax portion (employer contributions and earnings) must still be included in your gross income. If you roll over only part of the distribution, the first dollars rolled over are considered the pre-tax dollars. These same rules apply if you make a direct rollover to the Roth IRA”
I would avoid the whole discussion by converting after-tax contributions to Roth inside the plan as soon as they are made. If a plan for some strange reason does not allow in-plan Roth conversions of after-tax contributions, then there isn’t much you can do – the rollover can happen eventually once you terminate employment.
I went back to check, yes, I believe you are correct, only earnings from the after-tax money are considered in this case as it is considered to be a separate account. And you are correct, some record-keepers can’t track the after-tax bucket properly, thus you would need a TPA to do so accurately.
Sorry, the formula got cut off:
Amount of Distribution x Your After-Tax Contributions/Your Account Balance = After-Tax Portion Your Account Balance
Where account balance is the account balance of the after-tax plus earnings. So I believe that the quote I provided above was technically incorrect as they reference employer’s pre-tax contributions, but this is the understanding that some record-keepers might have if you can’t track the after-tax bucket separately. Oh, and by the way, this quote was from an IRS publication, so they can also be confused at times. It is all about the language in p575, it references annuity contracts, but after-tax bucket is treated as a separate account, so you don’t need to consider any other money types (assuming we can track this properly).