By Dr. Jim Dahle, WCI FounderWarning: We're getting into the weeds today. This is definitely NOT a back to basics post.
As discussed in a previous post, the Section 199A pass-thru business tax deduction has forced us to revamp a large part of our financial lives. This deduction, designed to keep pass-thru business owners (sole proprietorships, partnerships, and S Corps) competitive with C Corps after the Tax Cuts and Jobs Act of 2017 (TCJA), is our new largest deduction (it used to be retirement account contributions and charitable deductions). Rearranging our financial lives in order to maximize it is well worth our time and effort.
Roth vs Tax-Deferred 401(k) Contributions
For a long time, I have generally recommended that doctors in their peak earnings years preferentially use tax-deferred retirement accounts. This allows them to get a tax deduction now, enjoy tax-protected and asset-protected growth, and most importantly, score some extra money from the arbitrage available between their high marginal tax rate now and their usually lower tax rates later. However, I have also been careful to point out that there are exceptions to this rule, one of which is being a super-saver.
Now there is no dictionary definition of super-saver, but the idea behind it is if you are going to be well into the top tax bracket in retirement, you may want to rethink the traditional tax-deferred advice and instead make tax-free (Roth) contributions and maybe even do some Roth conversions, even at the top tax rate.
There are a number of advantages for the very wealthy to having a larger portion of their portfolio in Roth accounts:
- No required minimum distributions forcing you to move money from a tax-protected account to a taxable account
- More of your portfolio is in tax-protected accounts and thus grows faster
- A larger percentage of your heirs' inheritance can be stretched
- More ability to lower your tax bill in retirement
- A good hedge against rising tax rates
- Less likelihood of having an estate tax problem
- Better asset protection since more of the portfolio is in a retirement account instead of a taxable account
Despite those advantages, it's still the right move for most docs to do tax-deferred contributions because of that arbitrage between tax rates. However, over the last few years as The White Coat Investor has seen unexpected financial success, more and more I have found myself looking at our tax-deferred contributions and wondering if we were doing the right thing.
- We are certainly super-savers. Despite the kitchen renovation that has exploded into tearing off multiple walls of our house this Fall (more on that in future posts), generally living on 5-10% of your gross income has an interesting side effect of causing your portfolio to grow very rapidly despite large charitable contributions.
- It seems a virtual certainty at this point that our marginal tax rate in retirement will at least be the equivalent of the 32% tax bracket and quite possibly 37% if our success continues for just a few more years. (Ask me how this feels knowing there was no Roth TSP while I was in the military with a taxable income under $100K.)
- It is now quite possible that we will have an estate tax problem I never expected, especially if the estate tax exemption is lowered at some point in the future. While I fully expect to cure our estate tax problem by simply increasing gifting and charitable contributions, having more money in Roth accounts instead of tax-deferred + taxable accounts does reduce the size of our estate and provide more options.
All of that already had me thinking about changing over to Roth 401(k) contributions for the employee portion of our 401(k)s, but when the TCJA was passed, it was the final nail in the coffin. Not only was it quite likely that we were better off with Roth contributions, but now we weren't even getting a 37% deduction on our solo 401(k) employer contributions since they are subtracted from the Ordinary Business Income on which the 199A deduction is calculated. We were only getting a 37% * 80% = 29.6% deduction. It seems really silly to take a 29.6% deduction now knowing we would be paying at least 32% at withdrawal on that money. So we have decided to stop making those contributions starting in 2019.
The Mega Backdoor Roth IRA
So are we just going to invest in taxable? No way. Tax-protected growth and asset protection is just too valuable. Instead of making “employer contributions” to our solo 401(k), we're going to make employee after-tax contributions. We get no deduction for these contributions, and, if the 401(k) allows it, we can either do an instant Roth conversion of those funds inside the 401(k) or transfer the money to an outside Roth IRA, tax-free. This process (after-tax contributions + instant Roth conversion) is known as a Mega-Backdoor Roth IRA. If you thought a Backdoor Roth IRA was awesome, wait until you get a load of just how much money you contribute to a Roth IRA each year through a Mega Backdoor Roth IRA.
What we were doing before:
- $32K tax-deferred employer (self-match) contribution into my partnership 401(k)/PSP (I no longer make enough clinically to max it out)
- $30K tax-deferred contribution into partnership Cash Balance/Defined Benefit Plan
- $19K tax-deferred employee contribution into my WCI 401(k)
- $37K tax-deferred employer contribution into my WCI 401(k)
- $19K tax-deferred employee contribution into Katie's WCI 401(k)
- $37K tax-deferred employer contribution into Katie's WCI 401(k)
- $7K HSA contribution
- $6K into my Backdoor Roth IRA
- $6K into Katie's Backdoor Roth IRA
- Total tax-deferred contributions: $144K
- Total HSA contributions: $7K
- Total tax-free contributions: $12K
- Total tax-protected contributions: $163K
- Total tax-protected contributions adjusted for taxes (45.2% marginal rate): $98K
What we are doing now:
- $19K tax-deferred employee contribution into my partnership 401(k)/PSP (New plan this year allows employee contributions)
- $32K tax-deferred employer contribution into my partnership 401(k)/PSP
- $17.5K tax-deferred employee contribution into my partnership Cash Balance/Defined Benefit Plan (New plan this year affects my contribution)
- $56K after-tax contribution into my WCI 401(k)/Mega Backdoor Roth IRA
- $19K tax-deferred contribution into Katie's WCI 401(k)
- $37K after-tax contribution into Katie's WCI 401(k)/Mega Backdoor Roth IRA
- $7K HSA contribution
- $6K into my Backdoor Roth IRA
- $6K into Katie's Backdoor Roth IRA
- Total tax-deferred contributions: $87.5K
- Total HSA contributions: $7K
- Total tax-free contributions: $105K
- Total tax-protected contributions: $199.5K
- Total tax-protected contributions adjusted for taxes (45.2% marginal rate): $160K
I'm ignoring the savings we do for our kids (Roth IRAs, UGMAs, 529s) and our taxable account contributions (actually the majority of our savings these days) here. But just looking at the tax-protected accounts, we've gone from sheltering $163K to sheltering $199.5K. If you actually adjust those tax-deferred amounts for our current marginal tax rate of 45.2%, we've gone from $98K to $160K, a 63% increase. But wait, there's more.
Katie's Pay Cut
By going to after-tax contributions for Katie, Katie no longer needs to make as much money as she used to in order to max out the 401(k). So I gave myself a raise and cut her pay dramatically. Yup, our family is voluntarily contributing to the gender pay disparity. But there is a method to our madness. Think about it. The White Coat Investor, LLC files taxes as an S Corp.
How much salary does she need to be paid in order to be able to contribute $56K to a 401(k) as employee tax-deferred and employee after-tax contributions? Well, $56K plus enough to cover her payroll taxes. How much did she need to be paid in order to contribute $56K to a 401(k) as employee tax-deferred and employer tax-deferred contributions? Well, $37K/20% = $185K + enough to cover her payroll taxes. So she can take a 75% pay cut and still max out that account.
“What? I still don't get it? Why do you want to pay her less?”
Because, my young padawan, every dollar she gets paid as salary costs us 15.2% in payroll taxes. If we pay her $185K, we pay 12.4%*132,900 = $16,479.60 in Social Security taxes and 2.9%*185,000 = $5,365 in Medicare taxes. So we want to pay her as little as possible while still being able to max out that account and justify the salary to the IRS. (Since her job description is so flexible and those types of jobs typically don't pay very much, that's pretty easy to do. How many of you are paying full-time employees less than Katie is paid part-time?)
The issue, of course, is that the 199A deduction, at least at our income level, is partially based on the salaries our company pays. So if we pay her less money, our 199A deduction shrinks proportionally. That's no good. So what's the solution? We just pay me more. So she took a big pay cut and I got a big raise. Yay me! Overall, the total salary paid by the company will be similar so the 199A deduction will be similar.
So why did I get the raise instead of her? Are we sexist? Nope. Remember I have that other job down at the hospital. Even if I were only making $56K with WCI, I would still pay the maximum Social Security tax each year. That's not the case for Katie whose only job is with WCI. The bottom line is that we're saving Social Security taxes on the difference between the 2019 Social Security wage base ($132,900) and the salary we pay Katie (about $64,000). ($132,900-$64,00) * 12.4% = $8,544. There is no Medicare tax savings of course, since we're getting the same total salary as a couple and it's all subject to Medicare. And half of that SS tax we would have paid for Katie is deductible, so it's really only $6,613 we're saving but hey, $6,613 more than covers a luxurious six-day heli-skiing vacation. It's real money.
Other Retirement Account Changes
#1 Cash Balance Plan Contributions
The careful reader will notice a few other changes in our retirement account line-up for 2019. My cash balance plan contribution went down. I'm pretty annoyed with it, but we changed plans this year. The new one admittedly has a better design, but its structure has a nasty side effect for young super-savers. Whereas the old plan let everyone contribute up to $30K, in the new plan the contribution limits are determined by age.
- <35 $5K
- 36-40 $7.5K
- 41-45 $17.5K
- 46-50 $40K
- 51-55 $80K
- 56+ $120K
I turn 44 in 2019, so it'll still be a couple of years before this change works out better for me.
#2 Partnership 401(k) Over WCI 401(k)
You will notice I am now using my $19K employee contribution at the partnership 401(k) instead of the WCI 401(k). It made a lot of sense to use it in the WCI 401(k) when I was making more money practicing medicine than running WCI. Now the situation is reversed. I don't actually make enough clinically to max out the partnership 401(k) even if I use the employee contribution there, but I can contribute more overall if I use the employee contribution there instead of our individual 401(k). Our partnership's new 401(k)/PSP actually allows employee contributions now, so I will just do that.
#3 Tax-Deferred Partnership 401(k) Contributions
You will also notice that I am doing tax-deferred contributions to my partnership 401(k). Remember that income is not eligible for the 199A deduction because medicine is a specified service business and our taxable income is well over the $315-415K limit. So that deduction is still worth 37% (federal) to us rather than 29.6% like it would be in the WCI 401(k). Maybe we'll be in the 37% bracket in retirement, maybe we won't, but we'll certainly be in a bracket higher than 29.6%. At least for 2019, we'll continue to do tax-deferred contributions if they are available to us. We're only talking about $19K here anyway, the rest (both the profit-sharing portion and the cash balance contribution) have to be tax-deferred.
You will notice Katie's employee contribution is also tax-deferred. That income is deferred from her salary, and so doesn't count toward Ordinary Business Income for the 199A deduction, so it still provides us a 37% (federal) deduction. We'll continue to use that for 2019 for the same reasoning outlined above.
Additional Complexity Using a Mega Backdoor Roth IRA
It's pretty obvious to see the advantages of these changes for us. We're able to protect a ton more money after-tax, really maximize the value of our retirement accounts, and even lower our payroll taxes (pretty much a free lunch in our case). The big downside, unfortunately, is additional complexity. As if our financial lives weren't complex enough already.
For years we've had the WCI 401(k) at Vanguard. Vanguard's individual 401(k) has its issues. The customer service isn't awesome, they don't allow IRA rollovers, and until recently, they didn't let you buy the lower cost admiral shares funds. But it was good enough for our purposes for a long time. The big problem now, however, was that the Vanguard individual 401(k), at least the off-the-shelf version, doesn't allow after-tax employee contributions or in-service conversions/rollovers, the two features necessary to do a Mega Backdoor Roth IRA. As I looked around at the other off-the-shelf individual 401(k)s, (Fidelity, Schwab, eTrade, TD Ameritrade) I found that none of them really allowed this. I would need to go to a customized plan and I was going to need professional help to do so. And professional help is rarely free and often quite expensive.
A Customized Mega Backdoor Roth IRA Plan with Mysolo401k.net
After shopping around a bit, I settled on mysolo401k.net. The fees were low and their website actually discussed the Mega Backdoor Roth IRA in detail. I thought that was a good sign. Within minutes I had the head of the company, Mark Nolan JD, on the phone answering my questions. It was such a good experience I thought they would make a great new affiliate partner for The White Coat Investor. It's always easier to plug companies that I actually use. At first, they agreed to not only pay me an affiliate fee for new business I brought them, but also discount their fees from $795 up-front plus $125/year to $700 up-front plus $125/year. Win-win-win. Shortly after I did a podcast mentioning them, they backed out of the agreement and decided to just lower their fees to $500 up-front and $125/year. Lame for me, but it's still a win for you and for them. Maybe I can talk them into sponsoring a podcast or something down the road.
Another option for you could be Rocket Dollar ($100 off with code WHITECOATINVESTOR) or My 401K ($50 bonus for going through my link) who I do have affiliate deals with. They administer self-directed Solo 401(k)s and IRAs. Because it's self-directed, you can buy real estate properties on your own or leverage RE crowdfunding platforms like Equity Multiple, RealtyMogul, Fundrise, Roofstock, CrowdStreet, etc.
Choosing a Fund Custodian
There was an incredible amount of paperwork involved. Pages and pages and pages and pages and pages. You see, mysolo401k.net isn't going to function as the custodian of the funds. They had to go to either Schwab or Fidelity. I already had accounts at both (partnership 401(k) at Schwab and HSA/Credit Cards at Fidelity), but decided to go Fidelity because I thought I might just use the 0% ER index funds there. Of course, when there are two companies involved and 4 new accounts (a tax-deferred and an after-tax for both of us and we didn't bother with the Roth accounts since we figured we'd just do rollovers to our Vanguard Roth IRAs) a few minor things were screwed up and had to be redone. But I was impressed with how much better the service was from both companies than what I've come to expect from Vanguard.
Once I got our 401(k) money over to Fidelity, I was disappointed to discover that I couldn't buy the 0% ER Index Funds after all. No biggie, I just paid a $4.95 commission and bought Vanguard ETFs. This isn't my first rodeo, but I was surprised that Fidelity didn't want my business in that respect.
“Checkbook” 401(k)
Another great feature of having a 401(k) plan actually designed by someone who knows what the heck they are doing is that this is a self-directed “checkbook” 401(k). That means I can invest it in anything I want (except Fidelity 0% ER index funds apparently). I suspect I will eventually take advantage of this feature to move some of my very tax-inefficient debt real estate/hard money loan funds out of taxable and into tax-protected.
Take-Home Points
This post is long enough, let's wrap it up. Here are the take-home points:
- If you qualify for the 199A deduction, you might want to consider Roth and Mega Backdoor Roth 401(k) contributions.
- If you want to do a Mega Backdoor Roth IRA in your i401(k), you're going to need a customized plan.
- After-tax 401(k) contributions allow you to max out your 401(k) on much less income.
- Maximizing your use of retirement accounts helps you reach your financial goals faster and protect assets from creditors, but often introduces a lot of complexity to your financial life.
What do you think? Have you done a Mega Backdoor Roth IRA before? Did you make any changes to your retirement plans in response to the new 199A deduction?
We own a short term rental business. The company pays my wife guaranteed payments which she deposits into her solo 401k and then converts to Roth. From looking at out taxes, her income is multiplied first by 92.35% before the Self Employment (SE) taxes are calculated and then 50% of the tax is deductible. So the SE tax hit is not as severe as mentioned in your blog.
You pay 7.65%. Your employer pays 7.65%. The employer’s 7.65% is deductible to the employer. If you are both the employee and the employer, and your marginal tax rate is 40%, then your payroll tax is 7.65% + 7.65%*(1-40%) = 12.24%.
Hope that helps.
Hey WCI,
This was so informative. I’m a software engineer and not a doctor, so I hope you don’t mind my question here, which is: How much should one put into the Mega Backdoor Roth IRA, if they are single and haven’t yet bought a house.
I make 250K (including bonuses and stock) and my company started allowing mega backdoor roth ira contributions this year. I’m on track to maximizing every which retirement contribution/free money option that I can think of this year (401k, company match, backdoor and mega backdoor, hsa, espp). So, it leaves me with less savings in hand. Now I’m wondering how I should plan for potential pre-retirement expenses such as getting married and buying a house. It wont be possible if everything’s tied up in retirement accounts. Do you have any thoughts/resources for this situation? Do you also have any resources on what to do if your partner is going to be a lower income earner with high debt (60K income/200K debt)?
Thanks a ton,
Sunny
So how should you weigh your conflicting goals of retirement and buying a house? That’s kind of a personal budgeting question not an investing or tax question. It depends on when you want to buy a house, how much you have toward it, how much it will cost, when you want to retire, how much you have toward it, and how much you need for it.
One approach is simply to spend less so you can do both at once, but otherwise you’ll have to choose between earlier home ownership and earlier retirement.
If you are married to your partner, why not try to avoid taking on that debt in the first place by paying cash with your high income? Paying off debt is also an investment that provides a nice guaranteed return. But I wouldn’t pay off the debt of someone I was not yet married to. I recommend keeping finances separate until marriage and then combining them.
I disagree. Most marriages end in divorce. You don’t want to combine finances before both turn 50.
Also, consider getting a 30yr mortgage if you are buying a house. The investment return in your (retirement) account is generally higher than mortgage rate over time. And you have the option to pay it off early in favorable terms when opportunities arise.
Most marriages do not end in divorce. Among physicians, the number is even lower. 10-25% in most studies.
I don’t know of a study, but I bet if it were done it would show that combining finances at marriage results in a higher overall net worth than keeping them separate. Certainly marriage increases net worth, that’s been clearly shown.
As far as carrying debt to invest more, that’s a bit of a personal decision, but in my experience, most people don’t invest the money that would have gone to paying down the mortgage, they spend it. And that obviously comes out behind. It’s a behavioral thing. So even if the math works out, in practice it usually doesn’t. If you pay off your mortgage and regret it, you can always go get another one.
According to APA.ORG – “About 40 to 50 percent of married couples in the United States divorce. The divorce rate for subsequent marriages is even higher.”
So I win since 40-50 is less than most? 🙂
The stats for high income professionals are better than average, by the way. As low as 10% for a dual-doctor couple.
My situation is similar to one of the earlier questions but I just wanted to clarify a few things.
I’m leaving my current job and want to make absolutely certain I’m doing the right thing so I only have to do it once and not correct any mistakes.
I currently have a 403b through my employer with approx 5 years of contributions + match.
My new full time job also offers 403b with discretionary match.
I’ll also be starting a new 1099 job on the side which I suspect will make approx 100k per year.
I want to be able to do the backdoor Roth + mega backdoor Roth or at least leave those possiblities open.
My rough plan was to max out new 403b and then open tIRA + Roth IRA at Vanguard for backdoor.
I was also going to do solo401k but I can see that can’t be done at Vanguard for the reasons you say for mega backdoor.
Would you recommend I open solo401k in the manner you did or would using another service such as eTrade or Fidelity be fine for mega backdoor – that’s the part I’m not quite getting?
And would it be smart to rollover my old 403b into that solo401k or rollover over into my new 403b if the investments are good or makes no difference – again thinking I’d want to do mega backdoor?
I don’t think any of the off the shelf plans from Vanguard, Fidelity etc offer a Mega Backdoor Roth option. You would need a customized plan:
https://www.whitecoatinvestor.com/retirementaccounts/
Either option is fine for your old 403b. Just don’t roll it into an IRA.
WCI,
Thank you for the very interesting article. I have 2 tangential questions:
1. You implied you are able to take the 199a deduction while being in the 37% tax bracket. I know that many business types are excluded from an income cap but not physicians. I do physician clinical work for W2 income and will have 15-25K in 1099 income this year from speaking for pharma. We will have likely greater than 430K taxable income this year (married, jointly) and therefore I was told in the WCI forums (by Spiritrider, I believe) that I would not be eligible for the 199a deduction on my 1099 income. Is the fact that as a speaker I am still engaging as a physician the reason I cannot use 199a and with WCI you are not acting as a physician, the reason that you can use 199a?
2. I had a SEP-IRA that I rolled into my hospital system employer 401K 2 years ago. The money is segregated on my 401K statements. When it is mentioned that Vanguard does not take incoming rollovers to their i401K, does that refer to only IRA rollovers or also to 401K rollovers (I would only be able to roll over the money that came from the prior SEP but it is a significant amount).
Thank you!
My clinical work does not qualify for the 199A deduction. My WCI work does. My speaking income is a tiny sliver of my WCI income.
They’ll take 401k rollovers. Just not IRA rollovers. So I think you can do it no problem. But no guarantees. You’ll have to ask them.
How does the WCI work qualify for the 199a deduction? Is it the type of business structure, type of business or something else?
I ask again as I was told my taxable income (primarily due to my W2 income) is high enough that I would be ineligible for the 199a deduction on my much smaller 1099 income and I am in the 35% tax bracket this year while you reported you would be in the 37% bracket at the beginning of this post.
It’s not a specified service business. It isn’t practicing medicine, law, accounting etc. It’s a lot more like CNN than it is your practice.
I think I created a new post instead of replying directly so reposting with “reply”
So to clarify: my speaking side gig 1099 income (as a sole proprietor) should be eligible for the 199a deduction even if my clinician W2 income is above the specified service business cap?
One could argue that speaking is a specified service business too.
So to clarify: my speaking side gig 1099 income (as a sole proprietor) should be eligible for the 199a deduction even if my clinician W2 income is above the specified service business cap?
Thank you for your blog! I have learned so much from reading your very well written and personalized articles. I was going to open a solo 401k, but there seem to be some other (slightly cheaper) providers than mysolo401k. For example, this one also mentions mega backdoor:
https://www.solo401k.com/mega-backdoor-roth-ira-solo-401k/ Are there any specific features that you recommend looking for when choosing the provider?
My recommended list is here:
https://www.whitecoatinvestor.com/retirementaccounts/
I am an avid reader of your post. Big Fan!!! I found this article interesting. I am an ED Doc about our age. We currently make most (90%) of our income from 1099 sources. I file a schedule C as a sol proprietor and I have never felt the need to have an LLC etc as currently I have no other revenue streams other than our “day jobs”. Between my solo 401k, my wife’s 401k, HSA, and defined benefit plan I am able to reduce our AGI to take full advantage of the qualified business income deduction. We also do back door Roths. All told we save about 40% of our income towards retirement etc. I guess I am wondering if this mega back door roth is something I should consider?
Sounds like you’re in a very touch income range where if it goes too high you could lose the 199A deduction. In that case, doing MBDR contributions instead of your current tax-deferred contributions could cause you to not qualify for the 199A deduction. So sure, consider them, run the numbers, but it wouldn’t surprise me if you decided against doing them.
Why didn’t you just pay Katie a $56,000 salary, instead of paying her $64,000 to cover the extra payroll taxes? Everything I read is that the IRS allows 100% of compensation to go to retirement plans, but I cannot find anything about a requirement to cover 100% of compensation AND payroll tax costs. Her extra compensation ($8k) above the $56k limit costs you in extra payroll taxes doesn’t it? Thank you for this clarification.
Yes. But my understanding is you can’t put money that’s going toward payroll taxes into a retirement plan. First it is paid to you, then it goes into retirement. So payroll taxes must be paid first. When I’ve talked to retirement account specialists, they’ve confirmed that to me. I’d love to hear differently obviously.
IRA requires earned income. If you use up all earned income, $56k/$64k, in Katie’s solo 401k example, where does the additional $6k earned income come from to contribute in her individual Traditional/Roth IRA?
Spousal IRA doesn’t require her to have earned income as long as I have enough to cover her.
Yes, I am aware of that. I’m bring it up because I don’t know if we can use the employee payroll tax to max out (individual) IRA contribution. Technically that is still your earned income. Also, individual IRA contribution is done outside payroll. I’m leaning towards yes but I’m not a tax expert.
If it couldn’t be a spousal IRA, I’m not sure of the answer but I’m leaning toward no. Whether the IRS notices or not, I’m not sure.
I currently am able to max a mega backdoor Roth at my currently employer.
I have a job offer from a current consulting client, but they don’t currently offer a 401k with what’s necessary for a mega backdoor Roth. In lieu of this, they’re offering a ‘bonus’ to be paid to me while I’m 1099, with the idea I use it to max a solo 401k.
Issue is, as I understand it, I’d have to make ~$200k via 1099 to max a solo 401k because of the ~20% contribution limit. Before their ‘bonus’, I’ll make ~$100k for the year via 1099. If I can get to that ~$200k number between then ‘bonus’ and pre-paid salary, and everything else considered equal, do you think I’m losing much taking the offer? Income/self-employment taxes would be one thing for sure…
Basically I’m having a hard time putting a monetary value on being able to mega backdoor Roth. With compounding interest, it’s not just ~$57k to me. It’s worth a LOT.
I wouldn’t make a job decision primarily based on this factor, no. Chances are everything else is not “equal.” You can always just invest in taxable. It’s not even worth $57K. It’s worth the difference in taxes in a MegaBackdoor Roth and a taxable account. Sure, that adds up over decades, but it’s nothing at the beginning and not much for a few years.
Thanks for that. Clearly I’m overvaluing, and I’ll have to do some research to understand how/why. I’ve been thinking about ~$37.5k compounding in a Roth account for the next 20+ years and feeling like that value is far more than what I can set myself up for via taxable (I know nothing about taxable accounts at time of writing, as backdoor and mega backdoor have matched my ability to save)
For more context, I’m 32 and most everything about the offers are even, and I’m slightly leaning towards the offer, but losing the mega backdoor had given me serious pause, and I’ve been open about that so they want to know how to make me ‘whole’ essentially.
Roth is definitely better, but how much better is the question. I actually have this dilemma currently for next year for Katie. I can do taxable or I can do MBDR and pay an extra $6K in SS tax. Is it worth it? I’m thinking yes, but it’ll take a while for the advantages of Roth to make up for that cost.
Question:
I am employed my wife is not.
We receive 1099 income( comes in both our names) from rental property( comes from a property manager) Can I open a solo 401K for her and do the MBDroth?
Rental income is not earned income and thus is not eligible for contributions into retirement accounts.
How are you able to put away so much to your 401k’s? You mentioned that you are putting:
$19K tax-deferred employee contribution into my partnership 401(k)/PSP (New plan this year allows employee contributions)
$32K tax-deferred employer contribution into my partnership 401(k)/PSP
$56K after-tax contribution into my WCI 401(k)/Mega Backdoor Roth IRA
$19K tax-deferred contribution into Katie’s WCI 401(k)
$37K after-tax contribution into Katie’s WCI 401(k)/Mega Backdoor Roth IRA
That is a total of $163k a year into 401k’s for two people. I thought the max was 56K a year (if below age 50).
You’re going to love this post:
https://www.whitecoatinvestor.com/multiple-401k-rules/
Great, detailed, thorough article.
Why wouldn’t you use Fidelity’s low-cost index funds which are lower cost than comparable Vanguard funds?
Fidelity Total Market Index Fund FSKAX ER 0.015% (VTSAX 0.04%)
Fidelity Total International Index Fund FTIHX ER 0.060% (VTIAX 0.11%)
Fidelity Real Estate Index Fund FSRNX ER. 0.070% (VGSLX 0.12%)
First, it’s fine to use Fidelity’s excellent low cost index funds. For TSM and TISM, they even have funds with an ER of 0%. However, once you get down below 10 basis points in expense ratio, expense ratio is not where your focus should be when choosing an index fund as explained here:
https://www.whitecoatinvestor.com/expense-ratios/
I just left the following comment at another site. It may apply to some of your readers.
It should be noted that the tax benefit of employer contribution is questionable for most small business owners. The reason is that employer contribution reduces QBI which means losing the 20% QBI deduction. So at 24% marginal tax bracket, the contribution only defers 19.2% in taxes. Your contribution will be taxed at (likely much higher) full marginal tax rate, not today’s 19.2%, on withdrawal.
For this reason, most people should consider Roth contributions only. The mega backdoor Roth is the winner here. I strongly recommend using full service TPA for mega backdoor Roth because too much is at stake.
Really depends on the business. Most of the businesses owned by readers of this site are specified service businesses unfortunately, which at a certain income level are no longer eligible for the QBI deduction. More discussion of your point (which is mostly correct) here:
https://www.whitecoatinvestor.com/section-199a-deduction-qbi-and-retirement-accounts/
Hope everything went okay with your Mega Backdoor filing in 2019. I have started doing the same starting FY 2020 – Thanks to you!
Would you be able to share insights/learnings/guidance on tax filing for Mega? Just want to make sure I don’t mess things up.
Not sure how much I can help. It looks like Turbotax stuck it all in 4c on Form 1040. I don’t really recall how it got there to be honest. The money showed up as income on Line 1 as it was paid out to us as wages. So it is included in 7b, 8b, and 11b and then we pay tax on it on line 12b. The conversion, of course, doesn’t generate any taxable income since that money was already taxed. It’s definitely not on Form 8606 since that is for IRAs.
Do you have a specific question?
OOPS – I assumed this will all show up on 8606.
Okay, here’s my situation
#1 I contributed 6k to IRA post Tax which was later converted to roth (backdoor).
#2 During 2020 I also contributed amount X to post tax 401k on which I had gain of amount Y. When I withdrew this from 401k they gave me two checks – one (amount X – tax paid) to be deposited in Roth and another (amount Y – tax pending) to be deposited in IRA. Then I converted Y from IRA to Roth.
#3 so in total I had two conversion from IRA to Roth – one for backdoor 7k and another for mega backdoor amount Y.
Questions:
1. Will 6k + Y end up on 8606 with Y being taxable? Logically it seems so.
2. Does post tax conversion amount X get reported anywhere? Its definitely there in form 1099R issued by 401k provider. Is there another form to justify X was tax paid contribution?
Hope question makes more sense now.
1. Roth conversions from 401ks don’t go on Form 8606 as near as I can tell. Read instructions for line 8 and 16.
2. Maybe it comes in on a 1099R you enter in, but it’s not taxable so I wouldn’t expect it to go anywhere other than 1040 Line 4a if even there. The IRS doesn’t care so much about stuff that isn’t taxable.
Thanks!
So in this case would amount Y (Earnings on post tax 401k contribution) which was deposited to IRA and then converted to Roth, show up in 8606? After your message I looked at 8606, I am not sure how to clarify contribution of 6k (from backdoor) + Y in 8606.
When you did mega and backdoor both – did your form 8606 change? or you had no earnings in mega?
8606 does IRA stuff, not 401k stuff. So nothing you do with your 401K shows upon 8606.
No, there’s nothing from my Mega BDR on my 8606. It just documents my regular BDR.
I am considering starting a cash balance plan, to lower my income so I can Mega Back Door Roth into my individual 401k. I have contacted three different companies who can set up a cash balance plan and I have discussed with my accountant.
My concern is that the cash balance plan has an anemic internal rate of return (aka IRR) of 3-4% built into the plan, vs. the market which averages 10-12%. The CB plan would hold the conservative portion of my portfolio.
Is anyone else concerned about such low rates of return within a cash balance plan?
No, it’s generally recommended that you make the CB plan the conservative part of the portfolio.
You can set up your cash balance plan with the actual rate of return. That way you can have some control over the level of risk vs reward. Most advisors would still recommend a conservative asset allocation in order to decrease volatility. Our cash balance plan with a pretty conservative asset allocation returned between 8% and 9% annualized for the past 3 years.
I am still considering establishing the Cash Balance plan so I can mega back door Roth with money that received the 199A deduction. Other concerns:
Has anyone ever heard any changes to the tax laws that could jepordize this plan, given the new administration in office? For example, I read that Obama wanted to eliminate the Back Door Mega Roth option in the past, but it was spared. I have also read that Biden has no plans to eliminate the 199A deduction – at least as far as we know.
It would be nice to know if there are any tax law changes before I establish a CB plan, considering that it is a 5 year commitment.
I don’t know of any that are sure to pass, but there’s always stuff in the works and there will definitely be changes in the future. The 199A deduction goes away in 2025 under current law, of course.
I’m not sure what your reasoning is to do a CBP so you can do a MBDR. If you can do a MBDR, you can do a MBDR, whether you have a CBP or not.
The reasoning is that I phase out of the 199A deduction if I try to Roth into the i401k (instead of traditional).
I learned this the hard way last year.
Ahh…the donut hole. Got it. So you wanna Roth but make too much to do it without more tax-deferred contributions.
QUESTION: If I set up a self directed solo 401k and have 1099 income-can I have the whole 58K for 2021 go into after tax for the mega backdoor roth IRA or can I only do 58K-19.5(employee contribution) go into after tax ?
I do have a gov 457 that i max out at 19.5k yearly
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I know it will be complicated and time consuming. I will have to transfer my solo 401k from Vanguard into the self directed IRA(that I have yet to open)-then create two bank accounts–for tax deferred and for after tax, then will have to create a pooled account at Vanguard–move solo 401k part I want to invest in the stock market, possibly move solo 401k part I want to invest in hard money loans (how does that even get tracked?)and then additionally and separately move or convert after tax money and stick into roth ira account at Vanguard….
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QUESTION: any good books or blogs about doing taxes for such a project?
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i really hope the current administration doesn’t do away with this after I go through the above steps…
PS When you do the “conversion” -does your money from the Fidelity post tax account convert and go into your Vanguard roth IRA? How is this done?
I am really irked that Vanguard doesn’t allow for opening three /separate accounts tax def/roth/post tax and that the self directed solo 40k provider you used doesn’t allow for linking with the Vanguard pooled account. I have seen on Bogleheads there are other solo 401k providers that do allow linking with the Vanguard pooled account. However, I have concerns about tracking the money origins when its all pooled
Yes, you can do that. You contact Vanguard and they pull it over.
Our new 401k allows in-plan conversions of after-tax money too.
Yes, if the plan allows it.
Remember tax-deferred IRAs cause your Backdoor Roth IRA process to be prorated.
Why not just get a self-directed solo 401(K) from one of these folks: https://www.whitecoatinvestor.com/retirementaccounts/
thank you!
I dont have a regular IRA–or I should say it has 0 dollars(only used for backdoor conversions)
I have:
gov 457
local gov pension in the future (hopefully)
solo 401k at Vanguard
(backdoor) roth IRA at Vanguard.
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Yes I plan to open a self directed solo 401K at one of the online vendors–looking at discount solo401k, mysolo401K and Nabers solo401k….they basically all have the same name-its very confusing!
Once I open a self directed solo401k(and transfer funds from Vanguard) I can have : 1 tax deferred sub-account -for index funds and possibly hard money loan,2 roth sub account(I probably wont use) and 3 tax deferred account that I would then use for conversion to mega backdoor roth(and transfer back to my Vanguard roth IRA). My understanding is that I cannot have these accounts at Vanguard but will be able to at FIDO(although sucks that you cant get the zero cost funds) .
I have set up phone appts with the above three solo 401k providers and will go with most trustworthy (based on not sure what LOL) and cheapest. DH and I discussed whether to go with TPA or DIY it(documents for this self directed solo) and decided to try to DIY and DH does our taxes anyway.
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Have you transferred your DLP Lending fund investment into your solo tax deferred 401K and how does that process look? I know your loyal fans including this one would really appreciate a post/you tube video/podcast on this…hey maybe you can get DLP to sponsor it!
Not yet, but I think I will.
The Zero funds aren’t that awesome. I mean, the regular Fidelity funds have an ER of 0.015%. That’s indistinguishable from zero.
You can set up your cash balance plan with the actual rate of return. This way you can have some control over your risk vs. reward level. Most advisers would recommend a conservative resource allocation to reduce instability. With a pretty conservative asset allocation our cash balance plan has returned 8% to 9% annually for the past 3 years.
Yes, even a conservative asset allocation does well in a bull market. But people shouldn’t expect 8-9% out of a conservative asset allocation long-term.
How is your experience with Mysolo401k.net?
I am considering a cash balance plan + MBDR combo and most TPAs I’ve spoken to can offer a MBDR along with the CB plan, or they can offer a CB plan only, and do the MBDR with someone else.
My concern is the level of service with a discount MBDR provider (such as Mysolo401k.net, others), and staying on top of compliance issues. I am afraid there will be some new IRS rule in the future, that I don’t know about until it’s too late. I’m too busy with other stuff anyways.
Have you had any issues using a discount MBDR provider?
Is it worth paying an extra $400/year to have a professional TPA help?
Thank you!
My experience was fine (it’s over now as we no longer have a solo 401k since WCI now has employees.)
Good luck with your decision.
Dr. JD,
I currently have w2 and 1099, and I can make quite a bit ultimately with both of them, but the IC portion is likely to be low 6 figs this year. I may transition into working completely as a 1099 sooner than later. Let’s say (humor me) that I would like to do a solo 401k so I can get crypto and I think it’ll do amazingly well for at least the next 3 years, and beyond that, slow and greater gains moving towards my retirement (10-15 years). Is it worthwhile for me to do the mega back door Roth, then? Or is it too much of a hassle for the (estimated) gains?
I may also throttle down my 1099 work in any given year, but the potentially will always be there to eat what you kill, so I’m not quite sure yet. Thanks Doc
If you want to invest in crypto in a solo 401k make sure you get one that will allow you to do that. Most won’t.
If you expect massive returns, it would be best to have those in a retirement account such as a Roth IRA.
If you want to invest in crypto in a solo 401k make sure you get one that will allow you to do that. Most won’t.
If you expect massive returns, it would be best to have those in a retirement account such as a Roth IRA.
Read through the comments and haven’t seen this addressed – why are your CBP contributions maxed at such low numbers? Did your group adjust the projected retirement age, decrease overall projected end benefit, or something else?
Tables I’ve seen that include maximum 401k profit-sharing still show much higher potential CBP contributions by age. With lower total CBP contributions and I assume similar fees to maintain the plan does your group attain as much of a benefit as they could? Perhaps there was internal struggle to get all partners on board doing a CBP and thus agreed to lower contributions to limit plan risk? Just trying to understand the plan design. Thanks!
Not sure, wasn’t involved. It’s now a pretty large group of docs using it and only a tiny percentage were maxing it out before even at $30K a year.
To WCI,
When you had set up non-prototype 401K with Fidelity, you had to call every time to make after-tax 401K contribution? Is there an online transfer feature?
thank you for what you do.
I only make a contribution once a year, so even if I did have to call every time it wouldn’t be a big deal. But I don’t think I have to call. I just tell my COO (who does the HR stuff) how much I want put in there and he does it online somehow.
With my previous Solo 401k with the non-prototype 401k with Fidelity, I did probably send an email or two to get it all done properly.
Hi WCI,
I’m a fresh grad intensivist with W2 income plus some additional 1099 independent contractor income (~$50k). I max out my contributions on the W2 employee side ($19.5k), but wanted to somehow take advantage of the additional $38.5k employer contribution tax-protected space. My original plan was to setup a solo-401k, which would only allow me to shelter 20% of that $50k in traditional tax-deferred employer contributions (~$10k). However reading about Katie’s situation with the Mega BackDoor Roth, it sounds like setting up an account with mysolo401k.net would make it possible to max out my $38.5k employer contribution even on my $50k IC income. Is that true? and if so would the extra $28.5k of tax-protected space be worth the $125/yr management fee with mysolo401k.net?
My default is yes, $28.5k of additional tax-protected space is worth it, but I just want to make sure that I’m not missing something obvious?
Thanks for all that you do!
Yes.
I think so.
Bear in mind that your employer contributions to hour 401k is part of that 28k and there is a limit on how much of your 1099 you can contribute.
But yes it’s so worth doing!
After following you for a while I started doing mega backdoor and backdoor. At this moment me and my wife both work, Max out 401k, I also max out (based on what my employer allows – 6%) post tax 401k. My wife also has some business income but we don’t have an LLC. Is there a way for me to contribute some of business income to pre tax 401k to keep us in a more sensible tax bracket? Thanks
Your wife can contribute some of her business income to an individual 401(k), about 20% of net profit as an employer contribution. You don’t need an LLC, but you will need a free, easy EIN.
https://www.whitecoatinvestor.com/multiple-401k-rules/