Mega Backdoor Roth – A Perfect Fit for Solo 401(k) Plans

The mega backdoor Roth strategy is an advanced retirement savings technique that allows individuals to contribute significantly more money to a Roth IRA or 401(k) account than IRS contribution limits would typically permit. The catch? The strategy requires access to a 401(k) plan that allows voluntary contributions. Because voluntary contributions tend to fail nondiscrimination testing, few plans offer them. Solo 401(k) plans are exempt from nondiscrimination testing, making them the perfect fit for the Mega Backdoor Roth strategy.

If your business qualifies for a solo 401(k) plan, the mega backdoor Roth strategy can mean significant tax-free income for you in retirement. Here are the basics.

What is the Benefit of the Mega Backdoor Roth Strategy?

Roth IRA and 401(k) accounts are popular because they can offer an individual tax-free income in retirement. However, these accounts are subject to annual contribution limits that may not satisfy high-income individuals. For 2024, the Roth IRA limit is $7,000 ($8,000 if catch-up eligible), while the Roth 401(k) limit is $23,000 ($30,500 if catch-up eligible).

The Roth IRA limit is subject to an income-based phase out. The phase out can make direct contributions to a Roth IRA impossible for high-income individuals. Roth 401(k) contributions are not subject to an income limit.

By employing the two-step mega backdoor Roth strategy, any high-income individual can contribute as much as $69,000 ($76,500 if catch-up eligible) to a Roth account for 2024. They just need a 401(k) plan with the right features.

What 401(k) Features are Necessary for the Strategy?

A 401(k) plan must include the following features for a participant to maximize their mega backdoor contributions to a Roth account annually:

1. Roth contributions – contributed by employees on an after-tax basis. Their principal can be withdrawn tax-free because it was taxed prior to contribution.
2. Voluntary contributions – contributed on an after-tax basis like Roth contributions, but subject to different rules. Key differences between Roth and voluntary contributions include:
   • Roth contributions are subject to the 402(g) limit ($23,000 ($30,500 if catch-up eligible), while voluntary contributions are not.
   • 401(k) plans must test Roth contributions for nondiscrimination using the Actual Deferral Percentage (ADP) test, while the Actual Contribution Percentage (ACP) test must be used for voluntary contributions.
     • Safe harbor plans automatically pass the ADP test, while no plan – regardless of its safe harbor status – can avoid the ACP test when voluntary contributions are made.
   • The earnings on Roth contributions can be withdrawn tax-free when part of a “qualified distribution,” while the earnings on voluntary contributions are always taxable upon withdrawal.
3. Mechanism to convert voluntary contributions to Roth – an individual must convert voluntary contributions to Roth as soon as possible to minimize the taxes on any earnings. A 401(k) plan can offer active employees two options:
   • In-plan Roth rollover and/or transfer – necessary to convert voluntary contributions to Roth within a 401(k) account.
   • In-service distribution – necessary to roll voluntary contributions to a Roth IRA. Plans are allowed to permit the in-service distribution of voluntary contributions at any time.

Why Solo 401(k)s are Perfect for Mega Backdoor Roths

In general, Highly-Compensated Employees (HCEs) are more likely than non-HCEs to make voluntary contributions. As such, voluntary contributions can make the ACP nondiscrimination test impossible to pass when allowed by a plan. When the ACP test fails, substantial contribution refunds to HCEs are often the result.

Solo 401(k) plans are not subject to ACP testing because their participation is limited to business owners. In other words, non-HCEs cannot participate for a 401(k) plan to meet solo standards. That means a business owner can make voluntary contributions to a solo plan without the risk of contribution refunds.

How to Make a Mega Backdoor Roth Contribution

Making a mega backdoor contribution to Roth account is a two-step process:

1. Make after-tax contributions to a 401(k) account up to the 415 limit ($76,500 if catch-up eligible / $69,000 otherwise for 2024).
   • Contribute Roth contributions up to the 402(g) limit ($30,500 if catch-up eligible / $23,000 otherwise for 2024).
   • Contribute the remainder as voluntary contributions ($46,000 for 2023).
2. Convert the voluntary contributions to Roth:
   • Inside the 401(k) account via in-plan Roth rollover and/or transfer.
   • Outside the 401(k) account via Roth IRA rollover.

Any earnings on the voluntary contributions must be included in the individual’s taxable income in the year of conversion. Future earnings won’t be taxable if part of a “qualified distribution.”

Roth 401(k) accounts and IRAs have different pros and cons. Individuals should keep them in mind when choosing the best approach for converting voluntary contributions to Roth.

Could SECURE 2.0 Make the Strategy Obsolete?

SECURE 2.0 Act of 2022 (SECURE 2.0) became law on December 29, 2022. Section 604 allows 401(k) participants to characterize matching and profit sharing nonelective contributions as Roth if allowed by their plan. This SECURE 2.0 change is technically effective now, but adopting it now is a risky bet due to several unanswered administration questions.

Once these questions are addressed, Roth nonelective contributions may become a simpler way for business owners to maximize their after-tax contributions to a 401(k) account annually. Making in-plan mega backdoor Roth contributions less popular in the process.

In the meantime, there is no other way for business owners to make such substantial contributions to a Roth account annually. Eligible owners should give the strategy a hard look if they can afford it.