We’ve received numerous inquiries on the operational aspects of Roth provisions now that SECURE 2.0 expands the availability and benefits of Roth contributions in retirement plans.
In particular, I’ve seen a resurgence in Roth conversion questions. One much-discussed strategy is the Mega Backdoor Roth.
The driving force is Section 325 of SECURE 2.0. Effective for distributions due after January 1, 2024, required minimum distribution (RMD) rules for qualified plans will be on a level playing field with Roth IRAs, with the Roth accounts excluded from the pre-death amounts used to calculate the RMD.
Thus, the need to roll money from the plan to an IRA is eliminated for those participants who want to leave money in a Roth account as long as possible under the law.
Why It Matters
Individuals who expect to pay higher tax rates in the future may well want to pay taxes on their pre-tax savings (and earnings) now—and they may also want the flexibility to avoid the forced distribution (and taxation) of required minimum distributions (something Roths are not subject to).
What makes Roth contributions unique is that they are made with after-tax dollars, but once held in that account (subject to certain restrictions[i]), the earnings that accumulate are not subject to tax, nor are the contributions, which are made with after-tax money.
Note that while there are income limits on who can make a Roth contribution to an IRA, they do not apply to Roth 401(k) or Roth 403(b) accounts. However, the plan must allow Roth contributions, which not all do.
In addition to the Roth deferral component, SECURE 2.0 allows employers to design plan features where the participant may elect to have the matching or non-elective contributions made as Roth contributions.
Before the enactment of SECURE 2.0, conversions of pre-tax accounts to a Roth account were allowed if included in the plan provisions. However, the entire amount would be taxable in the year converted. Conversions are still allowed post-SECURE 2.0. IRAs also allow for conversion.
MEGA or Backdoor Roth Contributions
In a qualified plan that allows for after-tax employee contributions (again, this must be a provision in the plan), a participant may contribute the difference between their overall contribution limit ($66,000 for 2023 or $73,500 for those participants aged 50 or older) and the amounts already contributed via elective deferrals, forfeitures and employer contributions.
For example, suppose a participant who is age 45 has deferred $22,500 and received $22,500 in matches (and no other employer contributions or forfeiture allocations) decides to fund after-tax contributions. In this case, they may do so up to $21,000 ($66,000 – $22,500 – $22,500). Then, if the plan allows for Roth conversions, they can convert the amount to a Roth. If the plan does not allow for Roth conversion, the participant may take a distribution and roll it to a Roth IRA.
So, What Could Possibly Go Wrong?
Often forgotten is the fact that working with retirement plans is never quite that easy. Here are a couple of items to consider:
- Roth contributions or conversions are taxable in the year contributed or converted. This may prove quite a shock at tax filing time if there is no withholding or planning on the amounts.
- Each Roth conversion has a separate five-year tracking period to be a qualified distribution, so this may prove a challenge when record-keeping the amounts. Basically, you’ll pay the taxes now but would have to wait five years from the conversion for the Roth treatment to qualify. If you take distribution of the amounts before they are qualified for tax free distribution, the earnings will be taxable and perhaps subject to the additional 10% tax under Code Section 72(t) (if you’re under age 59½).
- After-tax contributions to a qualified plan like a 401(k) are subject to the ACP nondiscrimination test (even in a safe harbor plan). Therefore, a highly compensated individual who thinks they are utilizing the strategy may find that the conversion fails that test and has to have it refunded.
- We received a question about a test that failed but was run after the amount was distributed and rolled to a Roth IRA. In that case, the rollover would be ineligible and disgorged from the account (personally, this is not a conversation I would want to have with the participant).
- Of course, if the individual’s tax rate turns out to be lower in the future, then the tax benefit of this strategy may be lost.
Is it Worth it?
In summary, the Roth strategy may be right for you and your clients—but be sure they’re aware—or beware—of all the potential tax implications.
Robert M. Kaplan, CFP, CPC, QPA, QKC, QKA, is the Director of Technical Education at the American Retirement Association.
[i] Those conditions are that the account has been open for five calendar years, and the distribution is after attainment of age 59½ or the death or disability of the account holder.