I don't hear about new ideas very often, but here is one that a few people might find very useful. I call it the “Mega Backdoor Roth IRA.” There are several variations. Two of them work well for selected people, but after discussing the third with several retirement plan experts, it probably isn't a viable option.
Most of Us Don't Need the Mega Backdoor Roth IRA
Prior to getting into the variations, I need to point out that most physicians and most Americans probably don't want, don't need, or can't have a Mega Backdoor Roth IRA. An employee without the ability to contribute after-tax (not Roth) money to their 401K can't have one. A typical physician not maxing out his 401K and other tax-deferred options is probably better off with more tax-deferred space rather than more Roth space. A regular old boring Backdoor Roth IRA will allow most docs to have some tax diversification in retirement. A practice owner with multiple employees probably can't do a Mega Backdoor Roth IRA (the original impetus behind writing this post) due to profit-sharing laws.
So Who Should Consider Using a Mega Backdoor Roth IRA?
Three people.
- An employee with a very unique 401K.
- An independent contractor physician with no employees who needs more Roth space and is willing to give up tax-deferred space to get it.
- A very high-income physician who expects to still be well into the top bracket in retirement (i.e. his effective tax rate on tax-deferred accounts is very similar to his marginal tax rate during his working years.)
Variation # 1 – The Employee With a Unique 401K
Some 401Ks not only permit $17.5K of either tax-deferred or Roth contributions, but ALSO permit you to contribute your own, after-tax money into the plan up to the $52K limit. A good example of this is the TSP for deployed military doctors. It isn't a particularly good deal to just contribute after-tax money, UNLESS you can then get that money out and convert it to a Roth. Voila- A Mega Backdoor Roth IRA. Instead of only being able to contribute $5.5K per year, all of a sudden you can contribute $34.5K (plus the $5.5K in your personal and $5.5K in your spousal IRA.) If you're over 50 and put your first $23K (remember the $5.5K catch-up contribution) into a Roth 401K, you could potentially put up to $65K per year into a Roth IRA.
Here are the requirements:
- The plan must allow for after-tax contributions above and beyond the $17,500 employee contribution limit, preferably up to the $52,000 limit. So you can put in your $17,500 that is either tax-deferred or Roth, then contribute another $34,500 to the plan in after-tax dollars, similar to a non-deductible traditional IRA.
- The plan must allow for non-hardship in-service withdrawals of after-tax contributions.
- The plan should prohibit non-hardship in-service withdrawals of tax-deferred contributions (not mandatory, but a useful feature.)
- The plan should allow for “lump sum” contributions (not mandatory, but useful.)
Even if your plan doesn't allow in-service withdrawals (like the TSP), if you are separating soon from the company (or military), you may be able to isolate that basis and accomplish the same thing like I did after I left the military. This is a great deal for someone who has limited tax-protected (and asset-protected) accounts but would like to save more for retirement. Unfortunately, most 401Ks don't allow after-tax contributions. Check and see if yours does. Be sure the person you're asking understands you're not talking about Roth contributions, but contributions above and beyond the $17,500 limit.
Variation # 2 The High Income Independent Contractor
I usually recommend that a self-employed physician use an Individual 401K instead of a SEP-IRA. This is because you can max out an Individual 401K on less money, and 401K money isn't counted in the pro-rata calculation you must do when doing a regular old Backdoor Roth IRA. However, if you wish to do the Mega Backdoor Roth IRA, a SEP-IRA is probably the best option, since I don't know of an Individual 401K that allows both after-tax contributions and in-service withdrawals, although I wouldn't be surprised to see one that allowed in plan conversions, which are essentially the same thing. Typically, the person doing this is going to have a very high income, far higher than the average doctor, and would prefer Roth contributions to tax-deferred contributions.
Here is how it works:
- Contribute your $52K to a SEP-IRA like usual. You can make this contribution anytime between January 1 of the current year and April 15 of the next year.
- Convert your entire SEP-IRA to a Roth IRA. On your taxes, you'll deduct your SEP-IRA contributions, then pay tax on the conversion, but the net effect will be like contributing $52K to a Roth IRA. Be sure that you do your conversion prior to December 31st, as you do not want any money in the SEP-IRA on December 31st, lest you screw up the pro-rata calculation for your additional Backdoor Roth IRA.
- If you are concerned about the Step Doctrine, wait a few months between contribution and conversion. The tax burden won't be that much higher and it won't be that much more complicated.
Variation # 3 The Practice Owner's Uniquely Structured 401K
I've heard from a couple of people on this one, and the consensus seems to be that it is illegal, although if someone has some information showing that isn't true, I know some people who would be very interested.
The practice owner starts a 401K structured just like the one in variation # 1. However, instead of an employee, you are now the owner and responsible for the match and any profit-sharing contributions due to your employees.
You take these steps:
- Max out the employee contribution ($17,500) in either a Roth or traditional tax-deferred manner.
- Then contribute another $34,500 as a lump sum.
- Next, do an in-service rollover/transfer of the after-tax money to a traditional IRA. If the plan is written properly, you do not, and in fact cannot, withdraw the tax-deferred employee contribution. It stays behind in the 401K.
- Finally, convert the entire traditional IRA to a Roth IRA. This works just like the Backdoor Roth IRA, and you need to make sure you do not have any other traditional IRA, SEP-IRA, SIMPLE IRA money as of December 31st of that year. If you transfer directly to a Roth IRA (now allowed), then you can even have traditional/SEP/SIMPLE IRA money on the side.
When completed, you end up with $17,500 in the 401K and $34,500 in a Roth IRA. This allows you to tax-protect and asset-protect just as much money (more on an after-tax basis) as you would with a profit-sharing plan ($52,000 per year, more if you're over 50). The point of this plan is to save on any profit-sharing contributions you would have to make for your employees, (a significant expense for a practice owner employing nurses, mid-levels, or other doctors,) although you would still be required to pay for plan expenses and any regular 401K matching contributions. Of course, the employees may not be very appreciative of that, so you might not want to mention it. At any rate, I don't know of any retirement plan administrators willing to set up a small practice 401K into which the owner can make after-tax “employee” contributions, so it isn't much of an issue anyway.
What do you think? Do you use a Mega Backdoor Roth IRA? Would it be useful to you? Comment below!
Very interesting and creative. Not sure Id venture down this path but nice article about potential other options
Great article. One point of emphasis is it probably makes sense if you are converting a 401k or other type of DCP to a Roth IRA is to make sure to do it yearly. This will make it less likely you are going to get a huge tax hit by doing a massive lump sum Roth IRA conversion in 25 years.
Another more controversial point, and I would be interested to hear other people’s opinions about this, is to invest the the 401k/DCP funds that are intended to be converting to a yearly Roth IRA into a low-gain fund such as a short-term TIPS to minimize taxes at conversion, and then once those funds are in the Roth IRA pursue whatever asset allocation you may prefer (small cap value, etc)
I’m not sure that the idea of tips makes much sense. So what if the taxes are higher bc the gains are higher? You still have more money.
I agree. Remember the goal isn’t to reduce taxes, it is to maximize your after-tax money (at least on a risk-adjusted basis.)
I do number 1 on the difference between 52K and [17.5k + match]
On 3, why would it be illegal if they are the employee in 1 in achieving this. All employees have this option.
By the way – you do not need to go to IRA first, you can go direct to Roth IRA and pay tax on gains if you have any from the after tax subaccount of the 401k.
I do think though, for 3, with low number of low paid employees, the profit sharing component can be small enough that many will prefer just paying it so they can contribute pretax money instead of post. Also may be more expensive to get a 401k like this set up if it is uncommon in the small business realm.
I fall in the #2,but my income is not astronomical. ( 33% tax) So, if I convert my SEP with around 130k in it, what will be the tax hit? Will it be 33% of 130-52 =78K?
If you have a $130K SEP, and you convert it, and your marginal tax rate is 33%, then your tax due on that conversion will be $130K*33%=$42,900.
Great thoughts — this was a fun discussion we had at the company a few months ago, here’s some things I think you’re missing: I think you’re adding a few extra steps with the in-plan withdrawals to a Traditional IRA for individual 401(k)s. With the new (post ATRA) in-plan conversion options for 401(k)s, you can save a step:
http://www.irs.gov/pub/irs-tege/forum13_roth_conv_opps.pdf
“This means that all salary deferrals, any other employee contributions and all vested employer contributions made to your account, plus the earnings, may now be converted to a designated Roth account within that same plan.” – Slide 4
“And with the new within plan Roth conversion rules, after the employer contribution of $34,000 is made to the plan, you can convert it to a designated Roth account. Your new solo Roth 401k gives you a possible Roth total of $56,500 for the year. For some, that can be a real advantage for the Roth solo 401k plan.” – Slide 10
A few other notes:
– No recharacterization allowed: “once the account is converted it stays converted”
– Salary deferrals to Roth 401(k)s have age 59 ½ restriction (unlike basis available after 5 years in a backdoor Roth IRA)
– RMDs DO exist for Roth 401(k)s
– Additional info here: http://www.irs.gov/pub/irs-drop/n-13-74.pdf
While RMDs may exist for Roth 401(k)s (thanks for pointing that out by the way, I hadn’t realized that) there is a very simple workaround- transferring the funds to a Roth IRA, which doesn’t have an RMD requirement.
And there are potential advantages of conversion to a Roth-401k structure instead of in-service withdrawal to a Roth IRA.
For case 1 – your plan may have low rate institutional class funds that would not be available to you in an IRA.
Also, many states have better asset protection for assets inside a 401k compared to an IRA.
Advantages of IRA are wider choice of funds, and the additional flexibility after 5 years.
Thanks so much WCI for all the helpful posts!!
I think I can do a mega Roth 401k. I am a new partner paid on K1 and my groups 401k allows in-plan Roth conversion. So can I max my 401k at 53k then convert to Roth (and pay taxes of course). I just graduated so my income is reduced for 2015 to about 170. I though it might be a good time to take advantage of lower margins for roth conversion. 2016 I’ll make about 500k so may not do much Roth. What do you think? Good idea? Legal?
It’s legal as long as your plan allows it. And it seems like a good way to jumpstart your tax-free account. Obviously, it’ll cost you a bit in taxes.
I’m pretty sure case #3 won’t fly because the after-tax (non-Roth) contributions have to go through 401(m) non-discrimination testing. If the owner employee is the only one contributing after-tax, the test will likely fail.
Case #2 is just IRA conversion as usual. I can’t see why a high-earner would want to do that. The point of a backdoor Roth is that if you are not getting a deduction anyway, you might as well make it Roth. Here you get the deduction already. You are better off just to keep it pre-tax and convert at a later time.
So we a left with case #1, which is completely dependent on the employer. If you are lucky to have an employer with such a setup in their plan, take full advantage! It’s usually larger older employer who created their plan a long time ago (think well before 2000).
Ah, for case 3 – I assumed this was a 401k with a safe harbor (where you are on the hook for 3 to 4%) and you were just discussing getting out of profit sharing not safe harbor contribution.
A couple of comments on this great article:
1) A solo 401k at Vanguard can be set up to be Roth, so you can fund $52k with Roth assets from the start.
2) In-service withdrawals are definitely an option and can be written into a plan document. I wouldn’t do it though – instead just add the Roth feature to the 401k plan, and you are good to go.
Are you saying you can make a $52K direct Roth contribution? Or are you saying you do your $17.5K Roth contribution and a $34.5K tax-deferred contribution, and then immediately convert the $34.5K?
Good question. It does seem that my assumption of $52k in Roth contributions might be incorrect unless that’s allowed by the IRS. This is a great question to ask my TPA – I’ll let you know as soon as I get a reply.
Looks like IRS only allows $17,500/$23,000 Roth contribution. Oh well. So the ‘mega’ contribution can come from a spouse on the payroll for a total of 2x$17,500. and a combined backdoor IRA contribution of $11k for a total of $46k.
This post has stimulated my thinking…I’ve got
1) 125k SEP IRA (zero investment gains)
2) 11k 2013 & 2014 non-deductible TIRA (zero investment gains)
3) 401k after tax 25k (5k investment gains)
If I understand all this backdoor / mega-backdoor stuff correctly…I can:
1) Convert the SEP IRA to a Roth IRA, tax free
Net Result: I got tax write-off for putting into SEP IRA, and the gains as well as distributions will be tax free from the Roth IRA after a 5 year waiting period)
2) Covert the TIRAs to Roth IRA, tax free
Net Result: paid tax on TIRA funds (because salary too high for write off), but gains and distributions will be tax free from the Roth IRA after a 5 year waiting period.
3) Convert after-tax 401k contributions (20k) to Roth IRA, tax free
Net Result: paid tax on after-tax 401k contributions, but gains and distributions will be tax free from the Roth IRA after a 5 year waiting period.
4) And, going forward, I will put 34.5k into after-tax 401k every year (my plan allows this) and withdraw it (my plan also allows this) into my TIRA, then convert that 34.5k + 5.5k = 40k to Roth IRA each year.
Net Result: paid tax on after-tax 401k contributions and non-deductible TIRA, but gains and distributions on that 40k per year will be tax free from the Roth IRA after a 5 year waiting period.
Did I get that right???
If so, wow, I should have been doing all this for a long while…
Thanks for a mind-blowing post.
Mistake: I can’t convert the SEP IRA to Roth IRA tax free because that was pre-tax funds in, and in the Roth conversion, that 125k (even though no gains) would show up as income on my tax forms.
So, I should convert the SEP IRA to Solo 401k to get it out of the way for all the back door and mega back door Roth conversions.
That’s right.
Thanks for confirming my understanding of your post!
I’m marching forward with items 2-4.
Wow, this post is now tied with my other favorite post of yours (where I learned I could go up to 50k on the SEP because the 50k limit was per job, not per person…Turbo Tax always allowed it, but I thought it was a bug in Turbo until you clued me in).
Thanks again!!!
Update: everything has been working per plan above.
Only snag thus far: I have a pension contribution (13k per yr) and apparently that counts against the 52k max. So, I’m only going to be able to do 21.5k per year to this (ie 17.5 pre-tax + 13 pension + 21.5 after-tax = 52k).
Sidebar: if I go over the 52k, my employer refunds the overage as income…not sure in which tax year though. There may be an additional angle there.
Can you add more information as to where you found out that the pension contribution counts towards the 401K limit?
Hi WCI.
My father has 200k after tax in his 401k. 1.3M pretax. The goal is to get that after tax into a Roth ira. He is now self employed and has a solo 401k at ameritrade, which accepts rollovers. However, his old plan custodian will only do a direct rollover of the pretax and will make a check out to him for the aftertax. Is there a way that avoids IRS risk in isolating the basis and converting it to a Roth?
I remember reading posts from Alan S. Who stated IRS hasn’t challenged tandem rollovers yet, but could very well in the future…
Awesome! That’s exactly what you want to isolate the basis. They transfer the pre-tax to the solo 401(k) and send him a check for $200K. He puts that check into an IRA within 60 days and then converts it to a Roth IRA. Voila- Mega Backdoor Roth IRA.
An update on this topic: In the interim the IRS has issued a notice (Notice 2014-54 for the curious: http://www.irs.gov/pub/irs-drop/n-14-54.pdf) that clarifies the issue of the super or mega backdoor Roth.
The one main point that I took away from the notice was that the distribution of pre- and post-tax money from one’s 401(k)/403(b) follows a pro rata rule. In other words, to get all the post-tax money out from a 401(k) one would need to convert the whole pile, with the destinations a traditional IRA for the pre-tax money and a Roth IRA via conversion-at-no-cost for the after-tax component.
This would in turn require that one roll that traditional IRA money back into the 401(k) before doing a “standard” backdoor Roth, in order to not be hit by that, distinct pro rata rule.
Complicated. In my case I have a 401(a) for which participation is mandatory and whose monies sit in their own pot. I also have a 403(b) and a 457 available. Therefore, in theory I could sock away $81,000 post-tax under 2015 contribution limits: $5,500 “regular” backdoor Roths x me and my wife, $35,000 after-tax money converted to Roth via the above in the 403(b), $35,000 to the 457 similarly.
There are limitations, though:
1) My 403(b) and 457 plans must allow for both after-tax contributions and pre-termination rollover of funds. (I already know my 403(b) allows roll-ins so that part’s not an issue at least.)
2) These funds will be untouchable for 5 years as they’re conversions as opposed to contributions, which isn’t such a big deal for $11,000 per year, but is potentially more of an issue for $81,000.
As it is, I have ~$75,000 in tax-deferred space in which to play, so this issue is of only academic interest, plus saving $150k+ for retirement is probably unnecessary in a mathematical sense of what I want out of my retirement vs. current lifestyle. It’s still an interesting thought experiment for how much one can tweak the rules.
Most plans, unfortunately, don’t allow inservice rollovers. Few plans offer after-tax contributions. Have you checked yours? Everyone is excited about the mega backdoor Roth but the fact remains that it isn’t available to most people.
Can you have a SEP IRA and Solo 401k at the same time?
I know that you’ve mentioned have a backdoor roth IRA and solo 401k at the same time, but what about SEP IRA?
Yes but I wouldn’t recommend it and they share the same limit. It doesn’t give you an extra contribution $57K limit.
We have a plan that is now eligible as of a few weeks ago. Our company did not max out pension/profit sharing in 2014. Are we eligible to contribute “make up” contributions up until April or are we only able to do so within the plan year?
Check the plan document as it likely governs.
is it true that you cannot convert your SEP IRA till after you have the funds in the account for 2 years ?
I believe that is a SIMPLE IRA rule. http://www.irs.gov/Retirement-Plans/SIMPLE-IRA-Plan-FAQs-Distributions
Hi WCI. After you do mega backdoor Roth conversion and get Aftertax-401K funds transferred into Roth IRA, do you have to complete any particular tax form at end year (similiar to Form 8606 for the normal backdoor Roth)?
Additionally, is there anything you should do to ensure ROTH IRA custodian firms (such as TDAmeritrade, Etrade or Charles Schwab) would not classify the incoming aftertax-401K funds as current year’s contribution? That situation would be a mess.
I have been thinking about this for a while and wanted to ask you in person when you came to Tucson, but didn’t want to interrupt other people and take over the conversation. Great presentation by the way.
My wife and I have the potential of receiving a financial windfall soon which should be tax-free and we would like to get a lot of it into our Roth accounts.
I was trying to figure out how to do this because as far as I know, the U of A doesn’t let residents participate in the 401k plan, however that may have changed recently with the Banner takeover, I’ll look into that. I’m unsure of the next steps that I should take or if this is even possible in my situation. I don’t think that I can open an SEP IRA and contribute a sufficient amount because I only have about $3000 of 1099 income per year.
Do you have any suggestions, or should I just hold off until I have a job that has an appropriate 401k and allows me to contribute? Is it worth it to work as a 1099 employee for some time? Or should I just realize that time is on my side, put the monty in a taxable account, invest in Vanguard mutual funds with a 75/25 split of total stock market/total bond market, and slowly move the money into our Roths over the next 30 years?
Thanks
I can’t think of a good way for you to get much of it into tax-protected accounts, but it’s not like a taxable account is bad. You’ll have future income to max out accounts later. If they do let you use the 401(k), you can put it in there (living off it actually, and putting earned income into the 401(k)), then convert it when you leave (you could use the taxable account to pay for the conversion.)
WCI,
Great posts and great website. Very cool, especially for the average white goat guy or gal who are relatively naive about the business of business and investing.
I was looking at your variation #2 — it seems like I’m converting pre-tax sep to post tax roth — which slightly diff from variation #1. Am I correct?
Yes.
Many thanks for the quick reply.
Given my high tax bracket, I will maximize my other pre-tax space first. Although regular backdoor roth is a good idea regardless.
p.s Sorry about my freudian slip earlier — white coat, not white goat…although the way medicine is going and how the medical profession is “fighting back”, I understand why my brain went there.
I think I have a variation #4. What do you think?
I am a partner in a small group of docs, all payed on a K-1. No employees. We have a company 401K plan with a third party administrator. All the partners invest in the 401k through a brokerage of there choice, in what Fidelity calls a “non-prototype” or “investment only” 401k. The TPA keeps track of all the accounting and taxes etc, Fidelity does none of that, only investment. Sadly, Vanguard does not do these types of accounts, “For the benefit of” types of 401k accounts. But the amazing news is, in Fidelity for example, I can buy whatever I want; ETFs, stocks, mutual funds etc. I have unlimited choices. I am going to stick with Spartan Index funds, and even have access to “Advantage” shares (similar to Vanguards Admiral shares with super low ER.) The super amazing news is that I can do an “in-plan roth conversion.” From what it looks like, I can contribute 18k to my Roth 401K, 35K to my traditional 401K and then convert the 35k to Roth 401K. Viola! Mega Roth 401k!
Does this sound accurate? Legal?
Thanks so much WCI for this website and all your great advice!
That sounds like my 401(k)/PSP with Schwab through the PCRA.
Remember if you’re converting something that is tax-deferred to tax-free, that’s not a Mega backdoor Roth. That’s just a Roth conversion. If you were allowed to make after-tax contributions whose earnings were tax-deferred, and converted that, then that would be a Mega Backdoor Roth.
I’m sure your plan is legal if the plan allows it.
WCI,
Fianancial newbie here so forgive me if I don’t understand totally.
So I work at a large employer that falls into situation #1 above: has a 401k plan that allows after tax contributions and also allows in-service withdrawals. For the last 4 years I’ve only been maxing the pre-tax 18k and putting my extra money into normal taxable investments.
When I asked my CPA about this he seemed to think after-tax contributions to the 401k were not a good idea because I would run into the pro-rata rule (similar to backdoor roth) when I converted the after-tax yearly contribution to a roth IRA, thus incurring taxes. So is that maneuver not worth it if you have sizable 401k pre-tax balance? Should I just continue to invest in a taxable account or is there some way I can take advantage of the after-tax portion of my plan?
Thanks in advance.
Two questions. # 1 are you doing Roth 401(k) or tax-deferred 401(k) contributions. If Roth, no big deal given your in-service withdrawals. You just pull all your 401(k) money out every year to IRAs. The Roth money goes to a Roth IRA and the other money (after-tax plus taxable gains) goes to a traditional IRA and is then converted to a Roth at minimal cost. This is why most 401(k)s don’t allow in-service withdrawals- because tons of people would just pull the money out. If tax-deferred, that’s not such a hot idea, since it would disqualify you from doing backdoor Roth IRAs each year.
# 2 How does your 401(k) handle the inservice withdrawals. Does it have to come out pro-rata or not? If not, no big deal. If so, your CPA is probably right. But I don’t think this is specified by the IRS, but rather by the plan document. So read that and ask whoever knows the most about your particular plan.
Obviously if you can, a mega backdoor Roth is better than taxable. But if you can’t, no big deal.
Thanks for the info. I do tax-deferred 401k contributions and have a sizable tax deferred account. I was under the impression that’s first priority since 1) I’m in peak earning years and my marginal tax bracket is the maximum 40%. 2) I cant do backdoor roth due to sizable rollover IRA and roth IRA accounts from my/wife’s prior jobs and investing in roth when income was lower, so running into pro-rata rule there too (unless is there any way around this?)
Regarding the pro-rata rule for this “mega-backdoor roth” I was under the impression it was IRS rules not plan rules. My CPA explained that if, for example I had 190k saved in tax defered 401k plan and 10k this year in after-tax 401k contributions, then I tried to roll that 10k after tax money into a roth IRA then only 5% (10k divided by 10k + 190k) would be tax free. I’m not sure what he meant by tax free. Tax free on capital gains before rollover? Tax free gains going forward? Tax free when I withdraw? Its pretty confusing to me to be honest so not sure if I should just keep doing what I am already doing (18k in tax defered then rest in a taxable account). Some of my colleages seem to be using the after tax 401k but I’m not convinced they understand why either.
By tax-free he just means that’s your basis. I’d have to do some more research to know if the IRS mandates that withdrawals come out pro-rata. I was under the impression that they did not. If I were you, I’d bounce this off The Finance Buff. He has spent more time than I have understanding the Mega Backdoor Roth. Let me know what you hear. But from this article, I think he agrees with me on this point.
http://thefinancebuff.com/rollover-after-tax-to-roth.html
Just the after-tax 401(k) without the backdoor Roth is likely a good idea from an asset protection standpoint, but a bad idea from an expense/tax standpoint. Same reasons a non-deductible IRA isn’t usually worth doing unless you’re doing a backdoor Roth IRA.
Sounds good I will ask him.
It does appear to me that pro-rata does apply from reading the IRS rules (although these things seem so unecessarily complex I’m never sure):
https://www.irs.gov/Retirement-Plans/Rollovers-of-After-Tax-Contributions-in-Retirement-Plans
I wonder if a way to get around this is to rollover your entire 401k balance every year – tax deferred into a rollover IRA and after-tax into a roth IRA. Would that be beneficial?
Great link. Thanks for sharing. Looks like you’re right about just taking out the after-tax stuff. However, the work around isn’t a big deal. You take everything out every year, the tax-deferred goes to a traditional IRA and the after-tax to a Roth. Then you roll the traditional IRA back into the 401(k). Repeat next year. Similar to what I did with my after-tax TSP money when I got out of the service.
That seems to be a good idea. But is there any advantage to rolling your traditional IRA money back into your company 401k every year? Why not just keep it there?
Yes, so you can do an iddy biddy normal ol 5500 Roth IRA through the back door, no? Your traditional IRA has to be zero on December 31
Exactly. Rolling it back in allows the backdoor Roth. Not my rules, sorry. Talk to your Congressman.
Gotcha. I cant do normal backdoor anyway cause my wife has alot of IRAs and doesnt work so cant put them back into a 401k (as I understand it).
Backdoor Roths are individually. While she might not be able to do a backdoor Roth, you still might be able to.
So this means (based on IRS site, link again below) the only way to do this now is to convert the ENTIRE 401K to multiple destinations — the appropriate portion (pre-tax %) to a Traditional IRA, the appropriate portion (after-tax %) to a Roth IRA. Then, convert the ENTIRE TRADITIONAL IRA back into the 401K so you have an empty Traditional IRA to do the regular $5500 backdoor Roth each year. So this article and others saying you can do leave pre-tax alone and convert only after-rax are outdated?
Does that sound right?
https://www.irs.gov/retirement-plans/rollovers-of-after-tax-contributions-in-retirement-plans
Yes.
Just to clarify – If I fall under Option 1, but my 401k plan allows in service distributions only on the after tax contributions (i.e., I cannot do an in service distribution on my pre-tax 401k contributions), then the mega backdoor Roth will not work for me because the IRS requires that any partial distributions must include some pre-tax amount (i.e., pro rata rule). Correct?
No. Yours is the ideal situation. You can do after-tax contributions. Then you can do an in-service distribution. Then you can convert the rollover IRA to a Roth IRA tax free. Awesome for you! I don’t see any pro-rata issue.
Wouldn’t I need to convert the entire 401k though (both pre-tax and after tax) to avoid creating a problem with the pro rata rule? My plan does not allow this: the in service distributions are only allowed on the after tax portion.
No. The goal is to separate the basis if possible. The rules of your 401(k) allow you to do that easily. Since you can only pull out after-tax money, all money you pull out is after-tax. So when you do the conversion, there is nothing to pro-rate since it is all after-tax.
I see – got it. That’s great news! Thanks so much for clarifying!
Just wanted to run this by you as, i’ve kept reading old IRS rules, old posts, so i’m not sure what is allowed.
My 401(k) plan allows after-tax contributions, which i have started doing this year. I also have 2 options to get it to Roth accounts:
– The plan allows in-service withdrawals to an IRA or Roth IRA, and i can specify i just want to move out the after- tax portion. (The Roth IRA choice says this: “If you roll over money to a Roth IRA, the taxable amount must be included in your taxable income for the year.”)
– I also have the option to convert to Roth IRA within the plan twice per calendar year. I can specify just the after tax amount, and when i select it, it give me an estimate of what the reportable taxable income will be on the gains (about $20 right now).
Last point. I have about $100,000 in a rollover Traditional IRA – I have kept it there because it was from a pension plan, and if i keep it separate from my current 401(k) plan, i will be able to better keep track, as distributions from a pension plan are not subject to state income tax where I live.
I have not been able to do Back Door roth ira contributions because of this traditional IRA. My question is, would an in-service withdrawal be subject to the pro-rata IRA rules just like a Backdoor roth ira contribution? If so, probably not worth doing the in-service withdrawal, but may still be worth doing after-tax contributions and keeping them there. Would the after-tax to roth conversion within the 401(k) be subject to any tax because of the pro-rate rule? My first thought was no, since it never leaves the plan. However, i ran this question by an accountant and he said he thought the IRS might consider the pre-tax amounts WITHIN the 401(k) for pro-rata rule. Haven’t been able to find a good yes or no on this – thanks in advance!
Must be nice to have a plan like that.
Great question. If you stop in an IRA, the pro-rata rule would certainly apply. If you went directly from the plan to a Roth IRA or did an in plan conversion…I don’t know for sure but I don’t think so since line 8 of 8606 only asks about Roth conversions of IRAs.
Thanks for the Post.
If you max out your company 401 k (I do my personal contribution 17 with Roth 401k and the balance regular 401k)…
AND you do some independent contracting work and can contribute to an Individual 401k for 20-25K per year.
CAN you then convert the (independent 1099) individual 401k into a Roth every single year and then pay taxes on it each year? Seems like a great way to increase your Roth holdings if allowed??
thx for such a great blog. I recommend it to every resident I takl to about this stuff.. which is every one…
I’m sure you CAN but whether you should depends on your marginal tax rate. If your margins are 25% or higher I say it’s a bad idea.
Also, there are limits on a second i401k. As I understand it, If you max out the employee portion (18k) of your first 401k, the second i401k has no employee space left that can be tax deductible. You are left with only employer (35k) contribution. On a 1099 you are both employee and employer BUT the employer portion can only be up to 25% of profit. So if you want to put in 25k in a 1099 i401k you will have to profit 100k on that side business.
Not quite right, but very close. You can do 100% employer contributions into a second 401(k) up to $53K. Also, the 25% vs 20% number confuses a lot of people. It’s 25% not counting the contribution, or 20% counting the contribution, but really the same number. So if you make $100K, you employer contribution can be up to $20K, not $25K.
Thanks WCI. Not sure I understand yet then. Can you clarify something for me.
Lets say Primary job is on a K1 with 53k to 401k. $15,900 is the employee portion and 233% (max allowed) of that or $37,100 is employer contribution for a $53,000 total.
Now I have a small 1099 side gig and want to create an i401k. What are my options? Lets say I make $10,000, how much can I put into i401k?
$2,100 plus 25% of $7,900 = $4,075? or
$2,100 + 25% of $10,000 = $4,600? or
25% of $10,000 = $2,500 or
$10,000!!
or something else
(As I understand, IRS allows a total of 18k from ALL 401ks combined to be tax deductible. So 18k minus 15,900 from first 401k is where I am getting 2,100)
Thanks!
$2100 + 20% * ($10,000-employer portion of SE taxes) = ~ $4100.
If you’re going to convert the whole thing, a SEP-IRA may work just fine. You can do a Roth employee contribution into a solo 401(k) (but not if you use your employee contribution at your main job’s 401(k)). You can probably get an individual 401(k) that allows in service conversions but it might require a customized plan.
As always, extremely informative and helpful
I am somewhat confused by the process (though not as confused as HR). I am an employee at a major hospital corporation. I max out my 403b employee contributions, receive a 100% match up to 6% of compensation, and can contribute after tax to the plan. Due to HCE nondiscrimination testing, I am limited to 5% of compensation after tax. My plan allows inservice withdrawals of after tax money only.
After working there for 3 years I have roughly 75000 in employee contributions, 50000 in match, and 25000 in after tax.
I want to move my after tax out and roll over to a Roth IRA. My plan is happy to cut two checks, one for the after tax money and one for the pretax earnings. My hope was that I would just dump the after tax into a Roth IRA and pretax into traditional IRA, then subsequently convert to a roth and pay tax on the paltry earnings.
The documentation seems to state that the IRS considers the money taken out to be prorated based on total plan assets. Thus, even though the plan gives me a check for my after tax contributions of $25000, the IRS views this money as 4167 after tax (25000/150000*25000) and 20833 pretax (25000/150000*125000) based on the prorata formula. I could easily roll this pretax money back in to the 401k but this seems to be significantly less attractive than I first thought. Am I thinking about this correctly? What are other people doing in this regard?
I had to do something similar as discussed here:
https://www.whitecoatinvestor.com/how-to-get-your-tax-exempt-tsp-money-in-to-a-roth-ira/
I couldn’t find an easy answer for this question:
My hospital allows after tax contributions to a pension plan and thus I’ve been doing Roth conversions monthly with my after tax contributions this year.
Question is, my income bracket is high now around 35% but will be lower when I retire. Is the Roth still worth it since I will be paying higher taxes on the contributions now vs down the line I twenty years? I’ve also maxed out my pretax retirement funds with 403b and 457 plans(36k pretax)
I have an individual 401k at vanguard. Suppose I was limited to 20% of my business income as an employer, and contributed pre-tax $10,000 as an employer contribution, leaving 43k free. Could I then contribute 43k of after-tax earnings into the vanguard individual 401k — and then follow by rolling this money into a roth ira?
I don’t think you can do the Mega Backdoor Roth IRA with a vanilla Vanguard Individual 401(k). I’m pretty sure you can’t make after-tax contributions. I think you can design a custom plan and get that though. Konstantin Litovsky has helped some people do that.
I am still looking into whether to do sep IRA or solo 401 k- can you advise what should we do on top of what we are already doing?
and also see if mega backdoor entry roth is a worth while investment for us – for which we would need your service.
current scenario:
my husband is a physician and I am a pharmacist- our net income this year is 650,000
I contribute 18k with 5 % match at my employer with NO self employment income
+ 5500 Back door entry roth after tax at Vanguard.
my husband: works full time but starting some side physician practice this year still in the built up but he expect to make atleast 70-90 k next year. This year total self employment income will most likely come to 40,000 max.
He contribute 18K via employer towards 403b + 5500 back door entry after tax roth
so for his contribution towards solo 401k for the self employment income as employee is 0
As Employer he can contribute 20% of 40,000K – right? (~ 8000k) he anticipates to grow to atleast 70-80 k by next year.
Would it be beneficial to initiate the mega backdoor entry roth process this year? or wait till the next year?
and also what exactly do you do – step for megaroth- what does the TPA exactly do- full service. one.
do you have to choose your own banks like fidelity or scwabb open those3 accounts for him- first after obtaining the separate EIN or do folks like Nora take care of everything from guiding you step wise- opening accounts to everything?
Your advise will be appreciated.
thanks
Not sure what you’re asking. Does his employer allow him to make after-tax contributions and allow in-service wihdrawals of those after tax contributions? If not, it doesn’t sound like the mega backdoor Roth is an option for you.
Or maybe you’re asking if you get a custom plan design on an individual 401(k) and then do a megabackdoor Roth IRA there. You can probably do that if you want.
I think I’d probably just open an individual 401(k) for his self-employment income and put $8K in it and call it good. That gives you something like $40K into 401(k)/403(b)s, $11K into backdoor Roth IRAs, and $8K into an individual 401(k). How much more did you want to put toward retirement each year and why not just put it in taxable? I mean, if you’re putting $200K to retirement each year, maybe it’s worth some hassle to shelter a little more in some kind of a plan. if your goal is to put in $75K, I don’t think I’d bother.
Not seeing much of a role for a SEP-IRA unless you’re going to convert it all to Roth IRA each year.