Executing the Elusive Mega Backdoor Roth

Welcome to Part 5 of the FIRE small business series.

You can see the Introduction and summary of what we are talking about here.  You should also read the disclaimer:

***Disclaimer ***
This is written for educational purposes.  I am writing to explain my understanding of these principles.  Please, do your own research and talk to a licensed professional before putting this into practice.  The intent of this article is to aid in understanding, point you in the right direction, and to allow you to ask a licensed professional questions that may pertain to your individual situation.  If you see something wrong, please let me know with documentation, so that I can adjust and get all the information as correct as possible.
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Wow, ok… we’ve come a long way.  We’ve:

In the process of setting up this corporate 401k, we put into motion everything that allows for…

The elusive Mega Back Door Roth!!!

Really this just means that we allowed for after-tax contributions and in-service, non-hardship rollovers in the 401k plan by-laws.

What is the MegaBackDoor Roth?

We all know the restrictions on the 401k:

  • $18,000 in personal contributions
  • 25% matching on your salary
  • $54,000 Total Contributions to the account

Let’s pay ourselves $18,000 with a 25% match.  That means that we’ve maxed out our personal contribution, and the company has contributed $4,500 to the account, for a grand total of $22,500 for the year.

But, the max is $54,000, what about that other $31,500?  Can’t I do something with that?

If your plan allows for it, you can take after-tax money and contribute up to the max allowable in a 401k plan.  That money is then considered Roth money for all intents and purposes, and can be rolled into a Roth IRA.

That additional money, the $31,500 beyond the $22,500 in our example.  That’s what’s known as the MegaBackDoor Roth.  It’s a way to get around the $5,500 limit on a Roth IRA.  Fairly easy to understand from an employee perspective, right?

I will say this is pretty rare, I’ve never had access to this in any of the plans that I’ve been a part of outside of the one I manage.  And now I know why.  While it’s simple from an employee side, it’s super complicated to make happen from an employer perspective.

What happens on the employer side?

First, we’re gonna have to define some things and give a little background:

Highly Compensated Employees (HCE’s)

These are employees that either own more than 5% of the company or make more than $120K as of 2016, or a spouse/family member of someone that fits those criteria.  There’s a little bit more to it, but that’s the basics and good enough for most of what we are going to discuss.

Non-Highly Compensated Employees (NHCE’s)

This is super complicated… ready?  It’s the ones that don’t meet the criteria to be HCE’s.

Compliance testing

Compliance testing is something that the IRS does to make sure that the bourgeoisie (HCE) do not oppress the proletariat (NHCE) with their exorbitant contributions to tax advantaged retirement plans.  So, every year there are certain compliance tests that each plan administrator is supposed to submit to the powers that be.

There are two main types of compliance testing that go on in a 401k:

ADP Test – The ADP (Actual Deferral Percentage) Test looks at the amount of deferrals (Traditional and Roth) as a percentage of the gross income of the employees.  Take the total of all the employee deferrals divided by the total gross salary of those employees.

ACP Test – The ACP (Actual Contribution Percentage) Test looks at the total contributions to the plan by the employer.  It’s the same principle as the ADP test.  You take the total contribution of employer match divided by the total gross salary of the employees.

Calculating these compliance tests:

For each the ADP & ACP you have to calculate the percentages for all of your eligible HCE’s and your NHCE’s.  Then we have to compare them to each other.  The HCE’s cannot contribute more than the MAX of the LESSER of (NCHE % + 2% or 2 * NHCE %)  OR 1.25 * NHCE %.  If this compliance is not met, the HCE’s are returned the difference as taxable income to bring the plan into compliance.  Let’s look at an example:

HCE: Makes $100K, personally contributes $10K and then the company matches 25% of their contribution.
NHCE: Makes $100K, personally contributes $5k and then the company matches 25% of their contribution.

Step 1:

Calculate the ADP:
HCE: $10k/$100K = 10%
NHCE: $5k/$100K = 5%

This means that the HCE can only contribute a max of 7.25% or $7,250 (the MAX of the LESSER of (7% (2% + 5%) OR 10% (2* 5%)) OR 7.25% (1.25 * 5%), since 7% is less than 10%, we compare 7% to 7.25% and get 7.25%) and therefore the HCE would be returned $2,750 as taxable income or the company contributes more money to the NHCE accounts to bring the plan into compliance.

Step 2:

Calculate the ACP:
HCE: $2.5k/$100K = 2.5%
NHCE: $1.25K/$100K = 1.25%

This means that for the HCE the company can only contribute a max of 2.5% or $2,500 (the MAX of the LESSER of (3.25% (2% + 1.25%) OR 2.5% (2* 1.25%)) OR 1.56% (1.25 * 1.25%), since 2.5% is less than 3.25%, we compare 2.5% to 1.56% and get 2.5%) and therefore the 401k plan is in compliance with the ACP testing.  No adjustment needs to be made to the company match.

Both of these tests apply to all eligible employees.  So, if you have a bunch of NHCE’s that are eligible and not contributing, you have to incorporate a bunch of $0 contributions into your calculations. 0’s really pull down an average, so if you are a HCE, and you’re getting refunds from your 401k every year, get your sales hat on and either: get all the lower level employees to contribute more or get management to make your plan a safe harbor plan.

A Safe Harbor Plan?

To avoid all this compliance testing the IRS gave us an out.  There are two options, you must meet the minimum, but you can do more if you wish:

  1. Match 100% of the employee contribution up to 3% then match 50% up to 5%.  So employee gives 3% -> company gives 3%, employee 4% -> company 3.5%, employee 5% -> company 4%.
  2. Non-Elective contribution of 3%.  Basically the company gives everyone a 3% contribution, whether the employee contributes or not.

If your plan meets one of these two criteria, you don’t have to do the compliance testing.  Which is probably why you end up seeing these matching plans on many of your 401k’s.  It means that the bourgeois are taking full advantage of the plan and don’t want the IRS sniffing around.

So What??

I know what you’re thinking:
Great… The company has to do all this crap, good for them.  You didn’t explain why I can’t do a Mega Back Door Roth.

As it turns out, once you make an after-tax contribution to a 401k plan, the plan is now subject to the ACP tests, regardless if the Safe Harbor Provisions are met or not.  And in that ACP test, the after-tax contribution is added to the company contributions for all the calculations.

So, in our example above, the HCE cannot actually execute the MegaBackDoor Roth simply because the plan would be out of compliance as ACP test would fail.  Anything above the $2,500, would cause the HCE % to be above 2.5% and therefore would be returned to the HCE as over contributions.

But what if it’s a safe harbor plan?  Let’s look at another example with 4 employees with matching from Safe Harbor Plan #1 (match 100% up to 3% & 50% up to 5%):

HCE: Makes $100K and contributes $18K with match of $4,000
NHCE – A: Makes $50k and contributes $1,500 match of $1,500
NHCE – B: Makes $50k and contributes $0k with match $0
NHCE – C: Makes $50k and contributes $0k with match $0

ADP testing is irrelevant since the plan is safe harbor.

But now NHCE-A wants to add $1,000 to the plan after tax, what happens to the ACP test?

HCE: $4,000/$100k = 4%
NHCE (Total): ($1,500 + $1,000 + $0 + $0)/($50K + $50K + $50K) = 1.66%

To find our max % company contribution we find:

the MAX of
the LESSER of (3.66% (2% + 1.66%) OR 3.33% (2 * 1.66%) )
OR 2.08% (1.25 * 1.66%)

Since 3.33% is less than 3.66% we compare 3.33% to 2.08% and since 3.33% is more than 2.08%, we end up with the HCE limit at 3.33%.

Our plan now fails the ACP compliance testing (4% >3.33%) and this results in money being reduced in the HCE match.  By allowing the after tax contributions, the HCE would lose $677 from the company matching contributions.

If only the HCE tried to contribute the $1,000 after tax, their matching limit would be 2%, not 4%.  How?

HCE: ($4,000 + $1,000)/$100K = 5%
NHCE: ($1,500 + $0 + $0)/($50K + $50K + $50K) = 1%

To find our max % company contribution we find:

the MAX of
the LESSER of (3% (2% + 1%) OR 2% (2 * 1%))
OR 1.25% (1.25 * 1%))

Since 2% is less than 3% we compare 2% to 1.25% and since 2% is more than 1.25%, we end up with the HCE limit at 2%.  Therefore, the HCE would miss out on $2,000 of the company match (2% of $100k vs 4% of 100K) and get their $1,000 returned to them.

You can see just adding the availability of the MegaBackDoor can really throw a wrench into the management and contribution limits of the plan.  Specifically, it hurts the HCE’s, and who are the HCE’s?  Well, they’re probably in charge of the plan that you’re contributing to.  My guess is they don’t want to subject their plan to all this compliance testing, with potential loses of company matches just so some jackass can add $1,000 more to his ROTH IRA every year.  Sorry, welcome to the real world.

So what did we do?

We set things up a certain way to make all of this type of stuff happen:

  1. We made our employee’s start date Oct. 1, but made the 401k plan eligibility only after 90 days.  This conveniently made it so that the employee was only eligible at the turn of the year.  The reason we did this is so we didn’t have to worry about the compliance testing for the current year.  And why was this important?  Since we were matching 25% while under the Solo 401k, having the employee eligible during the same calendar year would subject us to compliance testing.  And as such, we would have been out of compliance which would have returned us quite a bit as taxable income from ineligible contributions.
  2. We set up our plan as a Safe Harbor.  The company contributes 10% to everyone regardless of each employee contribution.   We also kept track of the salary our employee makes during Q4 of the previous year.  We made a lump sum contribution during the following year once the employee was eligible.  That is a one time thing, and will give us some advantages if we want to attempt the MBDR the current year.

All in all, we took full advantage of the Mega Back Door during the small 3 month window we had at the end of last year.  We put in the after-tax money, our admin moved it into our accounts and then I invested it, no different than any other 401k contributions.  We rolled it over to our IRA after we filled out a simple form and the money goes directly into our Roth IRA at Vanguard. And BOOM!  MEGA BACKDOOR ROTH!!!   We ended up putting about $30K total into our Roth accounts this way, that is in addition to the normal contributions of $5,500 each.

But, with the turn of the new year, we aren’t going to take advantage of it.  We could, in theory, add an additional 2.5% (1.25 * 10% – 10%) of our salaries after-tax, but then we incur more costs as our third party admin will have to submit all the compliance testing paperwork, as we will no longer meet the safe harbor provisions.  Plus, every time we roll it over to our Roth IRAs we incur a fee for processing all the transfer paperwork.

So, is it worth it?

Maybe, maybe not.  Honestly, after having gone through the nuts and bolts of making it happen, I don’t think it is, at least from the management side.  If you’re not managing it, you’re a NHCE and it’s available to you, it might be worth looking into depending how much you want to put in.  But, if it’s a safe harbor plan… Good Luck!

Really, after you max out your pre-tax stuff, I think it’s actually easier and more efficient to simply put the money in a taxable account and worry about avoiding the various capital gains limits.  That way you will then have access to the full amount any time you wish, not just the contributions after a 5 year waiting period.

I know California always has it’s grubby hands out looking for cash, so yeah, we could avoid some of the state income tax, but really, we probably won’t be in CA when all this comes to pass.

Just by having a company and adjusting how money flows through it, we’ve optimized our taxes pretty well as it stands.  I don’t know that all this hassle is worth it to add an additional $1,000 to our Roth’s every year.  Besides, some people don’t think Roth’s are worth it at all.

On a positive note, I learned all of this, so now I am educating companies about these things.  And we actually got to participate in the elusive Mega Back Door Roth! It was only for a short time, but that has to give us some FIRE street cred, WIN!

16 Comments

  • SightseeMD March 7, 2018 at 5:03 am

    Very interesting and useful post as we are in the process of leaving the joys of employed practice for private practice. Thanks!

    Reply
    • Mr WoW March 7, 2018 at 8:46 pm

      Just be aware that you can’t typically pull this off with a solo 401k. Those are usually off the shelf, and they aren’t going to do all the compliance testing, etc for you. Although it shouldn’t be a big deal since it’s only employee and spouse eligible for the solo 401k.

      That being said, it’s a huge PITA to make this happen at a small business, as soon as you have a Big Boy 401k. You have to dance around all these regulations. And really you want your wages to be fairly low, See Article #3 in the series. So if your wages are low, and you can only contribute a small % of those wages, is it really worth all the extra hassle? That I’m not quite sure about.

      Reply
  • Gwen @ Fiery Millennials March 7, 2018 at 5:54 am

    My current employer matches the first 2% 300%, and then 100% up to 6%. Safe harbor for the win. BUT. No wonder they won’t put the MBR into place if they have to go through all that testing and crap. Hard to blame them!
    Gwen @ Fiery Millennials recently posted…Monthly Status Report: February 2018

    Reply
    • Mr WoW March 7, 2018 at 8:43 pm

      Well… yeah that’s a hell of a matching program too. if you make 100K and max that out the company is contirbuting an additional $10K if I understand correctly. (2*3 = 6K + 4 *1 = 4K) That means that the folks making $200k are pulling in $20k in matches, yeah sorry to the peon that wants to add an addition $100 to his Roth every year. Good Luck convincing them of that. That’s a hell of a matching plan… sheesh.

      Reply
  • Dads Dollars Debts March 7, 2018 at 7:07 am

    Not quite ready to pull this off yet, but some day…when my tax bracket falls much lower!

    Reply
    • Mr WoW March 7, 2018 at 8:39 pm

      Well what’s nice is that if you have enough surplus income you can use this in addition to the taxable account. It is a good thing, all in all. Especially in CA, as they tax everything as regular income. It’s really just a matter if you have access to it, or if it’s worth the hassle to go through with the whole thing.

      Reply
  • FullTimeFinance March 7, 2018 at 4:21 pm

    Itonically we wrote about this on the same day. My employer modified their safe harbor plan to allow after tax contributions this year. I’m waiting to see the fallout.
    FullTimeFinance recently posted…Odds And Ends: Pro Rata Rule and 401K Discrimination Tests

    Reply
    • Mr WoW March 7, 2018 at 8:38 pm

      Should be interesting. I know I was involved with a plan a little while back that kept returning me money. I didn’t really understand why, but I fully understand why now. It’s really interesting to see if from the other side.

      Reply
  • FIRECracker March 8, 2018 at 4:35 am

    Achievement unlocked: “FIRE street cred!” *high five*
    FIRECracker recently posted…The Yield Shield: Preferred Shares

    Reply
    • Mr WoW March 8, 2018 at 7:55 am

      *high five* We’re part of the cool club. Yes!!

      Reply
  • Fritz @ TheRetirementManifesto March 8, 2018 at 7:04 am

    I max out my 401(k) to the $50k level every year and roll over $30k via the Mega Back Door twice a year to my personal Roth, exactly as you describe. I LOVE IT! I also realize I’m very fortunate to have this option. I never knew about all of the complexities “behind the scenes”, impressive.
    Fritz @ TheRetirementManifesto recently posted…The Ten Commandments Of Retirement

    Reply
    • Mr WoW March 8, 2018 at 7:53 am

      Wow… sheesh. Yeah. That’s nice that you don’t have those issues.

      I’ve had one place where I was getting money from my 401k returned to me every year because of this stuff. Never knew why, just got frustrated each time.

      Reply
  • Eric March 29, 2018 at 6:41 pm

    Great write-up!

    I’ve been debating this given that my company offers the mega backdoor. Love this love of thinking:
    “After you max out your pre-tax stuff, I think it’s actually easier and more efficient to simply put the money in a taxable account and worry about avoiding the various capital gains limits. That way you will then have access to the full amount any time you wish, not just the contributions after a 5 year waiting period.”

    As you mention, the state income taxes are another concern though!

    Reply
    • Mr WoW March 30, 2018 at 1:11 pm

      If your company offers it, it might not be that bad of an idea. The real hassle is with the management of it.

      But as you mention, you’re locked into a retirement account. So that can cause some others hurdles if you actually want the money earlier than 59.5.

      Regardless, glad to have the discussion. And thanks for stopping by.

      Reply
  • Dustin July 2, 2018 at 12:26 pm

    When one would take the in-service distribution and roll it over to the Roth IRA, when is that amount available to withdraw from the Roth? Let’s assume the rollover did not include earnings, those were sent to the the Trad IRA.

    Reply

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