With a 20-year history, many Americans have heard of the Roth IRA and its benefit of taking tax-free withdrawals during retirement. Some have heard of the Backdoor Roth — making nondeductible contributions to traditional IRAs and converting them to Roth IRAs. A new Roth savings strategy, being labeled the “Mega Roth” (or Mega Backdoor Roth) has recently surfaced, Ascensus staff explain.
So what is a Mega Roth?
First, a “Mega” Roth is not an official term, not a new law, and not a new DOL or IRS concept. It is a goal for retirement plan participants to accumulate more savings in their retirement plan Roth accounts or in Roth IRAs. This strategy is being touted by some advisors as having a greater value this year because tax reform legislation enacted late in 2017 lowered tax rates starting for 2018. So, if rolling over pretax assets to Roth accounts, the tax hit may not be as high as in previous years for some individuals.
The appeal to a Roth is that retirees will have tax-free assets during retirement. All contributions to retirement plan Roth accounts and to Roth IRAs are made on an after-tax basis, and the generated earnings grow tax-deferred. Withdrawals, including the earnings, are tax-free when distributed if the individual meets certain requirements.
There are two Roth options in this strategy.
- Retirement plan designated Roth accounts (in 401(k), 403(b), or 457(b) plans)
- Roth IRAs
The general strategy works like is this.
- A participant defers up to the statutory contribution limit (IRC Sec. 402(g)), including catch-up contributions if eligible (age 50 or older). This deferral limit for 2018 is $18,500, plus $6,000 catch-up.
- The participant receives any employer match or profit sharing contributions.
- The participant contributes nondeductible employee (after-tax) contributions to the plan, up to the annual additions limit (IRC Sec. 415). This limit for 2018 is $55,000 and is the combination of all employer and employee contributions, excluding catch-up contributions.
- The participant then moves the nondeductible employee contributions, and if wishing to maximize the Roth, moves all of his money types, as in-plan rollovers to his Roth account or as rollovers to his Roth IRA (if he has a triggering event).
Retirement plans must be designed — or amended — to include the necessary provisions that would enable participants to take advantage of this strategy. But the Mega Roth is not for everyone and can cause some retirement plan testing issues. So plan sponsors and plan participants each should discuss this strategy with their tax or financial advisors before proceeding.
Important Items to Note
Here are a few items that employers and plan participants should be aware of.
- Nondeductible employee contributions are included in the plan’s actual contribution percentage (ACP) test, even if the plan is ADP/ACP test safe harbor. This can make it difficult for a plan to pass ACP testing because the participants who typically make nondeductible employee contributions are highly compensated employees (HCEs).
- Nondeductible employee contributions are typically distributable at any time, making it easier to include these assets in an in-plan Roth rollover or a rollover to a Roth IRA (assuming the plan can pass ACP testing). Other money types may be subject to a triggering event (e.g., age 59½, disability, termination from service, etc.), depending on the specific plan provisions.
- In-plan Roth rollovers and rollovers of pretax plan assets to Roth IRAs can result in a substantial tax hit if the participant rolls his entire balance over in one year. However, a participant can mitigate the tax implication by rolling over a portion of the balance over a number of years, thus spreading out the tax liability.
Other Options for High Income Earners
High income earners are fortunate to potentially have enough income to save well for retirement. But if their income is too high, they won’t be eligible for annual contributions to Roth IRAs. They need not, however, rule out Roth IRAs in their retirement planning strategies because they can use other methods, in addition to the Mega Roth, to fund Roth IRAs.
Retirement Plan Rollovers. Retirement plan participants who have pretax, nondeductible employee contribution, and/or designated Roth account assets can roll over these assets to Roth IRAs if they have a triggering event.
Traditional IRA Conversions. IRA owners can convert their traditional IRA assets to Roth IRAs.
Backdoor Roth IRA. Individuals who have too much income to qualify for Roth IRA contributions can make nondeductible contributions to a traditional IRA and convert it to a Roth IRA, but pro rata taxation rules apply.
For all of these transactions, any pretax assets that are moved to the Roth IRA are subject to income tax, so individuals should discuss these options with a competent tax advisor.
Opinions expressed are those of the author, and do not necessarily reflect the views of NTSA or its members.