The mega backdoor Roth IRA can be an appealing opportunity for advisors to differentiate their services and capture assets that may otherwise flow into 401(k) plans not in their book of business. Yet, the process can be complicated and often requires detailed evaluations of clients’ existing retirement assets and 401(k) programs. At a bare minimum, advisors should be familiar with the strategy in the event that they receive inquiries on the matter from their clients.
The mega backdoor Roth IRA can potentially allow clients to transfer up to $36,500 in after tax 401(k) contributions into tax-free Roth accounts annually. By conducting a backdoor Roth rollover, individuals can convert assets that are in tax deferred, after tax 401(k) accounts into tax-free Roth IRAs. The strategy is particularly appealing for individuals who would otherwise be ineligible to make Roth IRA contributions due to salary restrictions.
Salary restrictions, while preventing the direct funding of Roth IRAs, impose no limits on rolling assets into a Roth IRA. The technique recently gained attention in an article from TheWallStreetJournal.
In addition, it appears that the Congressional conference committee for the 2017 tax reform legislation has issued an explanatory statement that clears up certain legal questions about the funding of Roth IRAs.
Federal regulations limit the combined amount of income that individuals can allocate to the pretax and Roth components of their 401(k) accounts to $18,500 annually (The amount increases to $24,500 for individuals who are 50 or older.) Some plans offer an additional third option, which is an after-tax feature.
Unlike the Roth component of a 401(k) plan, investment earnings in the after-tax account are taxed when the assets are withdrawn, unless they are rolled over to an IRA. By rolling the assets to a Roth IRA, individuals can convert the after-tax money from a tax deferred 401(k) to a tax-free IRA.
In 2018, Federal regulations limit contributions to 401(k) plans to $55,000. The amount increases by $6,000 for individuals age 50 or older.
The $55,000 limit (or $61,000 for older individuals) includes the combination of pre-tax, 401(k) Roth, after tax employee contributions and employer matching contributions. For indivisuals under age 50, that means $36,500 could be potentially be directed to the after tax feature (in other words, the difference between the $55,000 maximum plan contribution limit and the combined total of the $18,500 pretax and Roth plan contributions.) The $36,500 is also offset by employer matching contributions.
A back of the envelop calculation can illustrate the appeal of a mega Roth. For example, assuming a 40 year old client receives a $10,000 matching contribution, the client will be able to contribute $26,500 [$55,000 minus the $10,000 company match and the $18,500 contribution to the pretax and Roth 401(k) feature].
After 25 years with a 7% annual return, the after tax account would be worth $1,728,956, of which approximately $1 million would be a result of investment gains. Assuming a 20% tax rate, the individual would have a $200,000 tax liability that could have been avoided if the assets have been rolled into a Roth IRA.
Advisors can differentiate themselves from their competitors by pitching the concept of a mega backdoor Roth and assessing if the strategy makes sense for each individual client. For example, when rolling assets from the after-tax portion of a 401(k) to a Roth, clients will have to pay taxes on investment gains that may have occurred within the after tax feature. Advisors should therefore be prepared to calculate the impact of paying the taxes up front.
Ideally, the assets would be rolled over before they produce investment gains. Advisors should also note that not all retirement plans offer after-tax features and, among plans that do offer the features, not all plans allow in-service rollovers. Advisors who take a comprehensive approach to financial planning, however, should already be familiar with the features of their clients' 401(k) plans.