Back-Door and Mega Back-Door Roth Reminders

Several articles within Perspectives have been written about Roth planning techniques. Taking advantage of Roth contribution strategies remains a good financial planning strategy as individuals consider higher income taxes that they may face in their retirement years. As a result, more attention than ever is being given to Roth IRAs, Roth 401(k)s, Roth conversions, as well as ‘back-door’ Roth IRA conversions, and even ‘mega back-door’ Roth 401(k) contributions using after-tax contributions.

For those less aware of this topic, Roth contributions have the opposite tax treatment of the original pre-tax IRA/401(k) contributions. More specifically, investors pay income tax at the time of the Roth contribution/conversion, but then do not pay any taxes at the time of qualified Roth withdrawals in the subsequent years. This means all investment gains within Roth accounts can be withdrawn without capital gains or income tax implications, which is quite attractive for most people.

Those more familiar with the Roth world realize there are many nuances to consider with the advanced Roth planning concepts, especially for back-door and mega back-door Roth conversions. The back-door Roth is accomplished by an individual making a nondeductible contribution to a traditional IRA or 401(k). The IRA/401(k) owner then promptly converts those contributed dollars from the traditional IRA/401(k) to a Roth IRA/401(k) with virtually no income tax consequences upon conversion. That said, there are some important conditions to consider before initiating these strategies.

Before electing a Roth IRA conversion, most will want to make sure pre-tax IRA contributions do not blend in with post-tax IRA contributions, otherwise the IRS’s pro rata rule will be invoked. This is commonly referred to as the “cream-in-the-coffee rule” and it can trigger potentially unwanted taxes upon a conversion. Once after-tax funds (the cream) are combined with the pre-tax contributions (the coffee) from all of the owner’s aggregated IRAs, every distribution from any one of the owner’s IRAs will include some cream (tax-free) and coffee (taxable). Pro rata calculations are assessed based on IRA balances at the end of each calendar year, and are applied across all IRAs, even if only after-tax contributions are made to one traditional IRA and all pre-tax contributions are made to another traditional IRA. For those caught in this pro rata rule trap, rolling their pre-tax contribution amounts from the traditional IRA’s to a 401(k) plan can help mitigate the problem. Since 401(k) accounts are not aggregated with IRA’s, they can be ignored when applying the pro rata rules. Fortunately, most 401(k) plans accept IRA rollovers, making this a helpful tool to avoid unwanted tax bills.

Mega back-door Roth 401(k) conversions are very compelling at first sight, but several conditions need to be met prior to implementation. For starters, the employer sponsored plan has to allow after-tax contributions and permit in-service distributions or in-plan Roth conversions. None of these features are generally considered default Plan elections, but they can be taken care of with plan document amendments by a willing employer.

Perhaps the larger issue for smaller employers comes with the ACP Non-Discrimination testing. All 401(k) plans must satisfy the IRS’s nondiscrimination testing rules, to ensure that the qualified plan does not favor highly compensated employees (HCE’s) at the expense of non-highly compensated employees (NHCE’s). Put simply, the HCE group is not allowed to receive a significantly higher percentage of their pay as retirement plan contributions than the NHCE’s. Mega back-door Roth contributions can cause testing failures for small companies pretty quickly, which is essentially negates the ability to pursue the strategy further.

Although the pro rata and ACP testing rules can create issues, the planning techniques are still worth consideration for many individuals and employers alike. With the promise of much higher income taxes in the future under the Biden administration’s recent income tax proposals, the opportunity to take tax-free distributions from a Roth IRA in retirement is something everyone with earned income should consider. How much a person can contribute into the Roth bucket year to year can vary based on several factors, including those described above, but Greenleaf Trust is available to help clients navigate the particulars of these advanced planning strategies at any time.