Would A Mega Backdoor Roth Work In Your 401(k) Plan?

A mega backdoor Roth conversion is a retirement plan strategy that can allow individuals to allocate money to the Roth tax strategy above and beyond both traditional 401(k) and IRA limits. When done correctly, the conversion of assets from traditional after-tax contributions in a 401(k) plan to a Roth account doesn’t trigger a taxable event. However, there are complexities and important testing challenges associated with a mega backdoor Roth conversion.

For a mega backdoor Roth conversion to work, a retirement plan must have certain plan design elements in place, including the following:

• Traditional after-tax contributions — To start the process, you must make traditional after-tax contributions. These aren’t the same as Roth contributions. To do that, your employer must allow traditional after-tax contributions in your 401(k) plan. According to a recent Vanguard study, in 2023, only 22% of retirement plans offered the ability to make after-tax contributions.
• In-plan Roth conversion or in-service withdrawal provisions – Once you’ve made your after-tax contributions to the plan, you must convert those contributions to the Roth format. To do so, you must either complete an in-plan Roth conversion or take an in-service withdrawal from the plan. One of these plan design features must be present in your plan for the conversion to work; however, not every employer offers one of these provisions, so it’s important to research your plan before attempting a mega backdoor Roth conversion.

Assuming your plan has the necessary design elements in place, it’s important to consider the potential discrimination testing challenges a company may face by offering a mega backdoor Roth strategy. In a recent episode of my 401(k) Roundtable podcast, I discussed these testing challenges with Alison Cohen, ERISA attorney and partner at Ferenczy Benefits Law Center.

According to Cohen, the testing challenge begins with the characteristics of participants who are attracted to the mega backdoor Roth option. “The people who traditionally can afford to make traditional after-tax contributions are your highly compensated employees,” shared Cohen. That’s because these are the individuals who exceed the income threshold for contributing directly to a Roth IRA.

This tendency presents challenges when the plan undergoes its annual Average Contribution Percentage test. “When you test ACP and the only people who are taking advantage of this are your highly compensated employees, the plan fails testing. As a result, all of those contributions are now subject to be refunded,” said Cohen. She mentioned that this presents particular challenges if participants have already converted those after-tax contributions to Roth assets, noting that “it can potentially cause some disqualification issues.”

In the Vanguard report cited above, only 9% of employees who are eligible to make after-tax contributions actually contribute in this manner. If your plan doesn’t offer a match on after-tax contributions, it’s unlikely there will be enough participation by non-highly compensated employees to pass the ACP test. If only highly compensated employees make after-tax contributions, and there is no match offered, the plan will likely fail its ACP test. If this happens, each HCE who contributed would need to receive a “refund” for some or even all their after-tax contributions. If an HCE had maxed out contributions for the year, this would result in an entire year of missed savings in the 401(k) plan.

To help with testing outcomes and increase your chance at success with a mega backdoor Roth strategy, a plan should have each of the following characteristics:

• Strong employer match — Matching contributions are tested with after-tax contributions. An employer match — and, even better, a strong employer match — will help participants contribute more after-tax dollars to the plan that can then be converted to Roth assets.
• High participation among all employees –Plans have a better chance of passing discrimination testing when they have strong participation by both highly compensated and non-highly compensated employees.
• High percentage of HCEs – Employers with a large percentage of highly paid employees in their overall workforce could be better set up to pass discrimination tests. Retirement plans may use a “top-paid group” option to determine their HCEs for the plan year. This means the HCE group is determined by identifying the top 20% of employees based on total compensation versus by the annual income threshold. With higher compensation, the contribution percentages of those employees could be lower as a group.

When available and designed correctly, a mega backdoor Roth strategy can be a powerful option to accelerate participants’ retirement savings and shelter a portion of their retirement savings from taxes. However, there are important plan design and testing issues to consider. To have the best chance of success with your mega backdoor Roth strategy, consult with a qualified retirement plan advisor to determine whether this strategy makes sense for your plan.