A Mega Backdoor Roth is a powerful retirement savings strategy that can allow you to contribute significantly more to a Roth account than the standard limits. It also provides the opportunity to take advantage of the maximum contribution allowed to a 401(k). This strategy is particularly beneficial for business owners with no employees, as it offers a way to increase retirement savings while enjoying tax advantages. It enables you to diversify your tax strategy, creating both pre-tax and tax-free accounts.
How It Works
Contribute to After-Tax 401(k): First, you make after-tax contributions to your 401(k) plan. The IRS allows total contributions (employee + employer + after-tax) up to $69,000 in 2024.
In-Plan Roth Conversion: Next, you convert these after-tax contributions to a Roth 401(k) or roll them over to a Roth IRA. This conversion allows the after-tax contributions to grow tax-free.
Example of the Math
Let's break down the numbers with an example:
Annual Salary: $125,000
401(k) Contribution Limits:
+ $23,000 Employee Pre-Tax or Roth Contributions
+ $31,250 Maximum Employer Contribution (maximum IRS allows = 25% of Annual Salary)
+ $14,750 Employee After-Tax Contribution
= $69,000 Annual IRS Maximum Contribution allowed to 401(k) Plan
Step-by-Step Calculation:
Maximize Employee Pre-Tax/Roth Contributions: $23,000
Maximize Tax Deductible Employer Contributions: $31,250
Remaining Space for After-Tax Contributions: $69,000 - $23,000 - $31,250 = $14,750
In this example an additional $14,750 could be contributed as after-tax, which can then be converted to a Roth account. This allows for added retirement savings using the same plan, otherwise this $14,750 of the annual contribution limit would go unused.
Why It's Best for Business Owners with No Employees
Business owners with no employees (solo 401(k) plans) have more flexibility in making large after-tax contributions without the constraints of IRS required non-discrimination testing. This makes it easy to maximize contributions and take full advantage of the Mega Backdoor Roth strategy.
Understanding Employer Contribution Limits in 401(k) Plans with a Cash Balance Plan
When a business owner has both a 401(k) plan and a Cash Balance Plan, often the IRS imposes lower employer contribution deduction limits on the 401(k) plan. This provides a new opportunity, as it allows for higher after-tax contributions, which can then be converted to a Roth account through a Mega Backdoor Roth strategy.
How It Works
Employer Contribution Limits: The IRS sets deduction limits for employer contributions to both the 401(k) and Cash Balance Plan. Generally, when there is a cash balance plan the employer contributions to the 401(k) are lower than if you only had a 401(k) plan.
After-Tax Contributions: With lower employer contributions, there is more room under the overall contribution limit for after-tax contributions, which can be converted to a Roth account.
Example of the Math
Let's break down the numbers with an example:
Annual Salary: $250,000
401(k) Contribution Limits:
+ $23,000 Employee Pre-Tax or Roth Contributions
+ $15,000 Maximum Employer Contribution (maximum IRS allows = 6% of Annual Salary)
+ $31,000 Employee After-Tax Contribution
= $69,000 Annual IRS Maximum Contribution allowed to 401(k) Plan
Step-by-Step Calculation:
Maximize Employee Pre-Tax/Roth Contributions: $23,000
Maximize Tax Deductible Employer Contributions: $15,000
Remaining Space for After-Tax Contributions: $69,000 - $23,000 - $15,000 = $31,000
In this example an additional $31,000 could be contributed as after-tax, which can then be converted to a Roth account. This allows for substantial added retirement savings using the same plan, plus you can contribute significantly more to a Roth account than you can using normal Roth IRA contributions.
Advantages of a Cash Balance Plan
A Cash Balance Plan is a type of defined benefit plan that allows for even higher contribution limits than a 401(k). When combined with a Mega Backdoor Roth, it offers several advantages:
Increased Savings: You can contribute larger amounts to the Cash Balance Plan, reducing taxable income significantly.
Tax Diversification: By using both a Cash Balance Plan and a Mega Backdoor Roth, you diversify your tax strategy, having both pre-tax and tax-free accounts.
Retirement Security: The combination of these plans provides a robust retirement savings strategy, ensuring a secure financial future.
Conclusion
The Mega Backdoor Roth is an excellent strategy for high-income earners, especially business owners with no employees. By maximizing after-tax contributions and converting them to a Roth account, you can significantly boost your retirement savings, enjoy tax-free growth on more assets and have more assets that are not taxed upon distribution.
When paired with a Cash Balance Plan, the benefits are even greater, offering a comprehensive approach to retirement planning. This approach maximizes retirement savings and offers significant tax benefits, making it an excellent option for business owners looking to optimize their retirement savings.
Significant documentation and elections are required by the IRS to properly execute these strategies. Specific provisions must be in the 401(k) plan, tax reporting is necessary and compliance with contribution and deduction limits can be complex. Make sure you have experienced professionals guiding you in the process.
If you have any questions or want more information, contact Nicholas Miller at nmiller@providence-retirement.com or book an appointment here on our website.