Many retirement savers are not aware that that a massive Roth contribution option for the self-employed or small business owner known as the “Mega Backdoor Roth” is available and that is even more popular than the “Backdoor Roth IRA.” This article will explore how the two types differ and explain how they each work. We’ll also dive into the rules of the strategies which will ensure you understand what you need to do.
- The Backdoor Roth is a strategy that allows anyone, regardless of income, to get retirement funds into the popular after-tax plan
- While the Backdoor Roth IRA is good, self-employed individuals have an advantage of using the Mega Backdoor Roth 401(k)
- So long as you follow the rules, you can have a tax-free retirement
The Roth IRA vs. Mega Backdoor Roth IRA
In 2023, the most one can contribute to a Roth IRA is $6,500 or $7,500 if at least age 50. In general, if you are single and earn more than $153,000 or married and filing jointly and earn more than $228,000, you are not permitted to make Roth IRA contributions. However, beginning in January 2010, anyone with a pretax IRA can do a conversion irrespective of income.
The main reason behind this rule change was to increase tax revenue after the financial crisis of previous years. Roth conversions generate immediate taxation on the amount of the conversion. Consequently, the Backdoor Roth IRA conversion strategy was born.
Why is the Roth IRA so Popular?
Three words: Tax-Free Retirement. If you like paying taxes, the Roth IRA is not for you. A Roth is funded with after-tax money. So long as you meet the requirements, you will never owe taxes on that money (or the income it generates) ever. This is the opposite of a traditional, or pretax, IRA. Contributions are made before your income is taxed. Therefore, you get an immediate tax break on whatever you contribute. However, distributions, including the earnings, will be taxable.
As mentioned, there are requirements to receive tax-free Roth money, but there are only two. First, you must be at least age 59 1/2. Easy enough, since retirement money shouldn’t be touched until later in life. Secondly, any Roth must have been open for at least five years. You cannot fund a Roth and expect to pull the money out, tax-free, in a year or two. This shouldn’t be an issue since time is on your side when accumulating retirement wealth.
Another great facet of the Roth IRA is that there are no required minimum distributions. Once you reach age 73, you must start withdrawing from your pretax IRA, no matter if you need the money or not. There is no such requirement for a Roth. It’s not mandatory to ever distribute those funds. They can continue to grow for as long as you want. If you’re lucky enough to not need those funds, you can pass them along to your beneficiaries, untouched.
Related: How to Make Roth Contributions No Matter Your Age
How Does the Backdoor Roth IRA Work?
As we stated in the opening, if you earn too much money, you cannot contribute to a Roth IRA. Let’s amend that to: you cannot directly contribute to a Roth IRA. This is where the “backdoor” comes in. The Backdoor Roth IRA is a strategy that allows you to contribute to a pretax IRA, and then convert to Roth. Because of the income limitations of an IRA, you will not receive a tax deduction on these contributions. If you left those funds right there, your distributions would also be taxable. So why do it?
The only reason one would generally contribute after-tax funds to a traditional IRA is to convert them to Roth. With the Backdoor Roth strategy, you would immediately convert the contribution to Roth. Because there would be no earnings on those funds, no taxes would be due.
Here’s how it works for someone just starting out:
- Open both a traditional and Roth IRA
- Make an after-tax contribution to the traditional IRA
- Work with your IRA custodian to complete the conversion
- The conversion would be reported on IRS Form 1099-R as a zero-tax conversion
The Backdoor Roth IRA can be done per person, so a married couple can go up to $13,000 or $15,000 if they are both age 50 or older.
Related: Can I do a Backdoor Roth every year?
The Mega Backdoor Roth 401(k)
This strategy is the best option available for Roth lovers, but there is a caveat . The Mega Backdoor Roth 401(k) strategy will allow a self-employed individual to set up a Solo 401(k) plan and get up to $66,000 ($73,500 if age 50+) in 2023 into a Roth on a dollar-for-dollar basis. The strategy is generally only available for Solo 401(k) plans since they are not subject to various ERISA annual plan testing rules which can limit its potential use for regular workplace 401(k) plans.
To establish a Solo 401(k) plan, one must have a business (can be a sole proprietorship) and not have any full-time employees. One of the major benefits of the plan is that allows for both employee and employer contributions. As with any 401(k) plan, anyone with earned income can make an employee deferral contribution of up to $22,500 plus an additional $7,500 if at least age 50. In addition, the self-employed can make a profit sharing (employer) contribution based on a percentage of your income. The total amount cannot exceed the maximum in a given year.
Solo 401(k) Plan After-Tax Contribution Mechanics
After-tax 401(k) contributions are not treated as either employee deferrals or employer profit sharing contributions and therefore, can be made on a dollar-for-dollar basis; Obviously, they are not tax-deductible. For example, an individual under the age of 50 making $90,000 in self-employment income can contribute the full $66,000 2023 limit into a Solo 401(k) plan in an after-tax basis. Alternatively, the same individual would be limited to a $40,500 contribution if done in pretax and/or Roth.
The idea is the same as the Backdoor Roth IRA – contribute as much as you can in after-tax dollars and then immediately convert to Roth.
How Does it Work?
IRS Notice 2014-54 opened the door to the Mega Backdoor Roth 401(k) strategy because it allowed for funds to be distributed from a 401(k) plan separately without a pro rata formula requirement. Below are the steps one can take to make these types of contributions:
- Establish a Solo 401(k) plan.
- Establish two bank accounts for the plan. In addition, if you expect to make pretax employee deferral contributions, it is suggested that a separate bank account also be opened for accounting simplicity purposes.
- Make a contribution into the plan’s after-tax bank account.
- Transfer those funds to the Roth plan bank account using the backdoor.
- (optional)You can then move those funds to a Roth IRA if you wish.
- The plan administrator will need to file IRS Form 1099-R in January of the following year to report the tax-free conversion.
Related: How do I build up my Roth IRA quick?
Deadline for making a Mega Backdoor Roth Contribution
The deadline for making a contribution is the date the adopting employer files its tax return, including extensions. Because the contribution is in after-tax funds, it does not impact the individual’s federal income tax return (IRS Form 1040).
In fact, you can even set up a plan immediately prior to filing the tax return and take advantage of the structure. For example, one can set-up a plan on October 14, 2023 and make a Mega Backdoor Roth contribution for the 2022 taxable year, so long as the adopting employer filed for an extension.
Conclusion
Although both strategies share many similarities, do not get confused by the Backdoor Roth IRA and the Mega Backdoor Roth 401(k). The both seem almost too good to be true; thankfully they are 100% legal.
Anyone who is otherwise eligible can engage in Backdoor Roth IRA – even if you are over the income thresholds for directly contributing to a Roth. However, you must satisfy the eligibility requirements to open a Solo 401(k) and utilize the Mega Backdoor, which is the obvious winner here for the sheer amount of annual contributions you can make.
One thing to remember is where you open your Solo 401(k) matters. Not all providers will offer a way through the backdoor, so it’s important to know the option is available if you need it.
Pay attention to the rules and work with the right professionals if you wish to employ either strategy. A tax nightmare can arise if you miss a step or try to withdraw funds too early. If you wish to learn more, please fill out a contact form with any questions and we can help you on your way to a tax-free future!
