I’ve read the articles and maybe you have too; articles about Mega Backdoor Roths (MBRs) that promise a lot – but maybe don’t explain all the issues they may cause for certain businesses or people. In this article, I'm going to review what a MBR is, how it works, and while it may be good choice for certain people, it’s usually a bad option for small businesses.
My colleague, Daniel Lee, explained Mega Backdoor Roths very well in his article, Unpacking the Mega Backdoor Roth IRA. In summary, after hitting your IRS limit of $19,500 (or $26,000 if you are 50 or older*), you can contribute after-tax contributions.
After-tax contributions are different from Roth contributions in that they are converted to Roth dollars, and this must be allowed by your company’s 401(k) plan. Many large employers offer this benefit, but for small businesses Mega BackDoor Roths rarely make sense.
Why a Mega Backdoor Roth Rarely Makes Sense for Small Businesses
A Mega Backdoor Roth rarely makes sense for small businesses because of discrimination testing, which is required of all 401(k) plans by the Department of Labor (DOL).
The DOL is concerned that too many benefits of a 401(k) go to owners and highly paid employees, as compared to rank-and-file employees.
Discrimination testing is not one test, but several tests, and each test looks at a specific part of the 401(k) plan. While one test reviews pre-tax/Roth contributions from paychecks, many plans use Safe Harbor features to automatically pass several discrimination tests.
For more information on this topic, please see the blog article, Why am I Getting Refunds From My 401(k)?
What About After-Tax Contributions?
For a Mega Backdoor Roth, you must add after-tax contributions as an option to the 401(k). Once those contributions are added, the DOL tests to ensure if owners and high earners are taking advantage of this benefit, that the rank-and-file in the organization are as well.
Our experience is that typically only owners and high earners are interested in saving more than $26k into their 401(k).
If you use after-tax contributions to save, those dollars are subject to testing. If no rank-and-file employees take advantage of after-tax contributions, owners would either need to be refunded their after-tax contributions, or the company would need to contribute after-tax dollars to employees on their behalf. The former essentially negates any opportunity to do the Mega Backdoor Roth. The latter would allow you to move forward with a Mega Backdoor Roth, but the contributions to employees in an after-tax manner may not be the best way to increase owners’ contributions.
Profit-sharing may be a better way, which would be using pre-tax dollars, which provides the company with a tax deduction. For more information on how business owners can save more then $60k a year into their 401(k), please read this blog article.
* 2021 Limits per IRS
While a Mega Backdoor Roth may not be the solution to many small business owners saving more into their retirement plan, there are other options that I’m happy to discuss. Please schedule time with me or call me directly if you would like a free consultation to review your plan.
This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.