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George F. Bearup, J.D. Senior Legal Trust Advisor

25-Aug-21

Backdoor Roth Strategy on Steroids? Maybe

Take-Away: As individuals start to seriously consider higher income taxes they may face in their retirement years, more attention is being given to Roth IRAs, Roth conversions, and ‘back-door’ Roth IRA conversions using after-tax contributions. In some circumstances, it might be possible to contribute substantial amounts to a Roth account each year using a  Roth 401(k) account, but this opportunity may not be available for everyone.

Background: Individuals now look for more ways to move more money into a Roth IRA, where there are no required minimum distributions and the earnings, with the passage of time, are income tax-free. However, the ability to transfer wealth to a Roth IRA is somewhat limited due to income and age limitations imposed on those who want to establish a Roth IRA.

Backdoor Roth IRAs: With the recent SECURE Act, Congress formally gave its blessing to the backdoor Roth conversion strategy. This strategy is often used for individuals whose income exceeds the limits to make a direct contribution to a Roth IRA. The backdoor Roth IRA strategy permits those high-income individuals to make a Roth contribution, albeit indirectly. This is accomplished by the individual making a nondeductible IRA contribution- for which there are no income or age restrictions- to a traditional IRA. The IRA owner then promptly converts those contributed dollars from the traditional IRA (holding only after-tax dollars) to a Roth IRA, virtually with no income tax consequences on the conversion. The backdoor Roth IRA strategy is limited, however,  to the amount of traditional IRA contributions that can be made in a year, i.e. $6,000 for 2021, or $7,000 if the individual is over the age 50 years.

‘Backdoor Roth on Steroids’: With this strategy, rather than make an indirect contribution with after tax dollars to a traditional IRA and then convert that IRA to a Roth IRA, the individual makes after-tax contributions to a 401(k) or a 403(b) account, and then converts those contributions to a Roth account, all while the individual is still working. Like the ‘basic’ backdoor Roth IRA conversion, this strategy takes advantage of the favorable income tax treatment of Roth IRA earnings when they are distributed (tax-free.) While the earnings on an after-tax regular 401(k) contribution are taxable when they are distributed, the earnings on Roth 401(k)  distributions are tax-free if made as a qualified distribution. Unlike the backdoor Roth IRA which is limited to $6,000 to $7,000 a year contribution, this strategy using a Roth 401(k) account to receive  after-tax contributions can potentially involve much higher amounts annually contributed to the Roth 401(k) account.

  • 401(k) Annual Limits: The higher contribution amount is because 401(k) contributions are subject to two separate annual limits: (i) the elective deferral limit, and (ii) the overall IRC 415 limit. The elective deferral limit restricts the aggregate amount of pre-tax and Roth 401(k) annual contributions to a maximum amount: $19,500 for participants, or $26,000 for participants who are over the age of 50 years.
  • No Limits on After-Tax Contributions: However, after-tax contributions are not subject to the elective deferral limit. Rather, those after-tax contributions are subject to a higher overall limit that caps the sum of all contributions made on behalf of the participant ( i.e. pre-tax, Roth, after-tax, and employer contributions) to a maximum amount for 2021 of $58,000, or $64,500 for those participants who are over the age of 50 years.

Example: Jim, age 45, is a salaried employee who earns $200,000 a year. Jim’s employer and plan sponsor offers a 401(k) plan that accepts (i) pre-tax and (ii) after-tax and (iii) Roth contributions. Jim’s employer also provides a matching contribution. Jim would like to maximize his Roth 401(k) contribution for the year and also take advantage of the backdoor ‘Roth on steroids’ contribution strategy. Jim contributes the maximum amount of $19,500 to his 401(k) Roth account. Jim also receives a $3,000 match from his employer. Jim could also contribute as much as $35,500 [$58,000 (-) $19,500 (-) $3,000= $35,000] of after-tax contributions in 2021 to his Roth 401(k) account.

Multiple Conditions to the ‘Backdoor Roth on Steroids’: Not every 401(k) plan participant can take advantage of the ‘backdoor Roth on steroids’ strategy, though. Sadly, this is not as easy as it may appear to be to exploit the fact that after-tax contributions are not subject to the elective deferral limit, the rule upon which the ‘backdoor Roth on steroids’ contribution strategy is based. Some of those conditions are obvious, while others are not so obvious.

  • Disposable Income: The 401(k) participant must have enough disposable income to contribute large amounts of after-tax contributions to his or her Roth 401(k) account:
  • 401(k) Plan Accepts After-Tax Contributions: The employer-sponsor’s 401(k) plan must offer the feature of accepting after-tax contributions; qualified plan sponsors are not required to offer this after-tax contribution feature, and many qualified plans, especially those sponsored by smaller employers, do not accept after-tax contributions.
  • 401(k) Plan Permits In-Service Distributions: The employer-sponsor’s plan is not required to allow in-service distributions, which can prove to be expensive for the plan sponsor. [Some plans, though, may alternatively permit plan participants to do an ‘in-plan’ conversion, in which after-tax contributions and other non-Roth contributions are able to be converted to a Roth account established within the qualified plan.]
  • Pro Rata Rule- Cream-in-the Coffee: We have covered this rule several times in the past, recall the cream-in-the-coffee rule on distributions from retirement accounts that hold both pre-tax and after-tax contributions. Any in-service distribution of after-tax contributions is subject to the Tax Code’s pro rata The pro rata rule dictates how much of a distribution is taxable when the account holds both after-tax contributions and pre-tax contributions. The taxable portion of each distribution is the amount of earnings on the after-tax contributions divided by the balance of the separate account. That amount will be taxable unless rolled over to a traditional IRA account; the remaining portion is nontaxable.

Example: Barbara participates in her employer Rothco, Inc’s 401(k) plan that allows her to make after-tax contributions. The 401(k) plan also separately accounts for Barbara’s after-tax contributions and their earnings. Barbara’s 401(k) account consists of $27,000 of after-tax contributions and $3,000 earnings. Barbara leverages the plan’s in-service distribution option and uses the ‘backdoor Roth on steroids’ strategy to convert $20,000 of that amount to a Roth IRA. Barbara cannot ‘cherry-pick’ $20,000 of her after-tax contributions to gain a completely tax-free conversion to the Roth IRA. Rather, the pro rata rule requires that 10% of Barbara’s distribution [$3,000/$30,000 = 10%, or $2,000 of the distribution] of the withdrawal is taxable. The balance of Barbara’s withdrawal, $18,000, will be tax-free. Note, too,  that Barbara could avoid the tax on the $2,000 amount by rolling that amount to a traditional IRA.

  • ACP Non-Discrimination ‘Test:’ The ‘backdoor Roth on steroids’ plan must also satisfy the IRS’s nondiscrimination testing rules, to ensure that the qualified plan does not favor highly compensated employees at the expense of non-highly compensated employees. Highly compensated employees are either (i) those who own more than 5% of the plan sponsor during the current or prior year; or (ii) for the prior year they received compensation more than an indexed dollar amount, e.g. $130,000 for 2020; or (iii) the plan sponsor may choose to limit highly compensated employees who are also in the top 20% of employees ranked by their pay. A small employer sponsored 401(k) which only employs the owner and his/her spouse as participants would work, since a solo 401(k) plan does not have to meet either of these two nondiscrimination ‘tests.’

Two ‘Tests:’ Many 401(k) plans have to pass two separate nondiscrimination ‘tests’ each plan year: (i) the actual deferral percentage (ADP); and (ii) the actual contribution percentage (ACP.)

ADP: The ADP ‘test’ regulates pre-tax contribution deferrals and Roth contributions, so the ADP ‘test’ probably does not impact the ‘backdoor Roth on steroids’ strategy.

ACP: The ACP test regulates after-tax contributions and employer matching contributions. Accordingly,  the ACP ‘test’ can pose a major challenge to a participant’s use the ‘backdoor Roth on steroids’ strategy. While the Tax Code does provide a safe harbor for the ACP ‘test’ either with an employer’s across-the-board contribution for all employees or a matching contribution for those employees who choose to defer their compensation with contributions to the 401(k) plan, the problem is that safe harbor contributions made by the employer do not relieve the qualified plan from testing after-tax contributions to the plan. In short, the adoption of safe harbor contributions may not enable the backdoor strategy to be pursued.

Example: Rothco, Inc.  sponsors a 401(k) plan in 2021. Rothco has 4 non-highly compensated employees (#1-#4) and 2 highly compensated employees (A and  B). The 4 non-highly compensated Rothco employees earn the following compensation and each makes 401(k) plan contribution percentages related to their compensation as follows: (#1- $40,000 pay, 0%  contribution; #2- $50,000 compensation, 1% contribution; #3- $70,000 compensation, 2% contribution, and #4- $90,000 compensation, 5% contribution. Rothco’s two highly compensated employees earn the following compensation and make the following contributions: A- $140,000 compensation, 8% contribution; B- $200,000 compensation, 10% contribution. Accordingly, the non-highly compensated employees average contribution percentage is 2% [ 0%+ 1%+ 2%+ 5% /4= 2%.] The average contribution percentage of the highly compensated employees is 9% [8%+ 10%/2= 9%.]  Under the ACP ‘rule’ the highly compensated employees’ average contribution percentage cannot be more than twice the non-highly compensated employees’ average contribution percentage. Therefore, the Rothco 401(k) plan will fail the ACP ‘test’ for 2021 since the maximum ACP percentage contribution for the highly compensated employees could only be 4% [2% more than the ACP for the non-highly compensated employees.]

Conclusion: For individuals who are still working and who want to convert large amounts of their 401(k) account after-tax contributions to a Roth IRA, the ‘backdoor Roth on steroids’ strategy is something for them to consider. The 401(k) plan must contain all of the features  that are mentioned above, and even when they all exist, the plan might still ultimately fail to meet the nondiscrimination ACP ‘test’ since after-tax contributions are included in that nondiscrimination ‘test’ determination. However, a for a solo 401(k) plan, this strategy could be a viable option since solo 401(k) plans are subject to neither the ADP nor the ACP ‘tests.’