Investors love to contribute and use Roth funds because of their tax-free growth. The trouble is you’re typically limited in how much you can contribute to a Roth IRA. Contributions to Roth IRA have a ceiling of $6,500 per year. The Solo 401k Roth limits are much higher at $23,500 but still – what if you could get more after-tax dollars to grow tax free? Enter the Mega Backdoor Roth using the Solo 401k plan.
What is it?
The mega backdoor Roth Solo 401k allows you to contribute more after-tax dollars than you would in a normal Roth IRA. By contributing money into the Solo 401k plan, you can convert those dollars to Roth funds. With this strategy, you can put more money into a Roth Solo 401k or Roth IRA than otherwise possible. The result is that you can eventually take the funds out of the Roth 401k/IRA without tax penalty.
The IRS recognizes the Mega Backdoor Roth as a legitimate strategy. In 2014 they released guidance on documenting after-tax contributions. The strategy grew out of the original backdoor Roth IRA conversion where investors would take contributions to their 401k or traditional IRA, convert them to Roth (and pay the taxes) and then roll those Roth funds into a Roth IRA. This is an especially valuable strategy for high-earners who don’t qualify to contribute directly to a Roth IRA or those who want to get more savings and assets into a Roth IRA structure.
Disclaimer: This is a complex strategy that requires meticulous calculation and excellent documentation. The Nabers Group Solo 401k plan allows for all elements of the mega backdoor Roth Solo 401k. However, we recommend you get help from your CPA or tax advisor before executing this strategy to ensure it’s done properly.
How does it work?
To exercise a Mega Backdoor Roth Solo 401k, the plan documents must contain:
- Voluntary after-tax contributions
- In-plan Roth conversions/In-service distributions
Your Nabers Group Solo 401k contains all the elements needed for the mega backdoor Roth strategy.
Decide how much you’d like to get into your Roth account. Then, allocate how much will be a Roth contribution (if any) and how much will be a voluntary after-tax contribution. Roth 401k contributions can roll into a Roth IRA almost any time. Voluntary after-tax contributions are converted to Roth funds once they are in the plan.
Converting after-tax contributions to Roth is not a taxable event as the funds are already after-tax. Rather, you are re-classifying the voluntary after-tax contributions to Roth funds.
IMPORTANT: Keep in mind that once you convert/re-classify your voluntary after-tax contributions to Roth funds, they must follow the rules for Roth distributions in order to be qualified. Once you convert after-tax funds to Roth, they cannot be turned back!
Once you make the voluntary after-tax contribution, you can either convert those funds “in-plan” to be part of your Roth Solo 401k, or withdraw/rollover those funds to your Roth IRA. The result? Instead of making $6,500 in Roth IRA contributions, you can make up to $76,500 in mega backdoor Roth IRA contributions. That’s almost a ten-fold difference in Roth IRA funds!
How to Move Money to Roth Solo 401k
- Decide and make your voluntary after-tax contributions
- Convert voluntary after-tax contributions to Roth 401k funds
- Complete an in-plan Roth conversion form (provided by Nabers Group) and file IRS form 1099-R to document the conversion. No taxes are due on converting voluntary after-tax contributions to Roth
How to Move Money to Roth IRA
- Decide and make your voluntary after-tax contributions
- Withdraw funds to your Roth IRAConvert voluntary after-tax contributions to Roth 401k fundsDecide how much you plan to convert to Roth using this strategy (voluntary after-tax contributions)
- Complete an in-service withdrawal form (provided by Nabers Group) and file IRS form 1099-R to document the conversion. No taxes are due on converting voluntary after-tax contributions to Roth
Logistics:
- Voluntary after-tax contributions are not the same as Roth contributions. While both are “after-tax” money, the Roth funds have their own rules and regulations around when they can be distributed from the plan
- Open three bank accounts for your Solo 401k: A) Traditional (pre-tax) funds, B) Roth funds, C) after-tax funds. Label each account with a distinct nickname on your online banking portal to keep funds in their preferred “bucket”
- Open a separate bank account (or three) for your spouse for easier record-keeping. Once after-tax contributions are made into their separate accounts, you can do internal in-plan Roth conversion
- Have your CPA or tax advisor help with the 1099-R to document the in-plan Roth conversion of voluntary after-tax funds
- After tax contributions are just like pre-tax and Roth contributions which means they are calculated based on the earned income you receive in your business
- With the Nabers Group Solo 401k plan, your voluntary after-tax contributions may be up to 100% of your net earnings from your business
The mega backdoor Roth strategy can be a powerful tool for growing your Roth funds. When executed properly, you can position yourself for tax-free distributions from your retirement plan. This is an excellent aggressive wealth tool because you will pay less in taxes in the long-run. However, always work with your tax advisor to ensure proper reporting and filing of forms documenting the conversion of Roth funds.
