Mega Roth Strategy Could Benefit High Income Earners
by Christle Johnson, QKA, CIP
Many Americans are aware of the Roth IRA and its benefit of taking tax-free withdrawals during retirement. Some have even heard of the backdoor Roth—the concept of making nondeductible contributions to a Traditional IRA and converting them to a Roth IRA. And recently, a new Roth savings strategy, being labeled the “mega Roth” (or “mega backdoor Roth”) has surfaced.
Mega Roth
The “mega Roth” is not an official term, not a new law, and not a new Department of Labor or IRS concept. Rather, it is a goal for retirement plan participants to accumulate more savings in their retirement plan Roth accounts or in their 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.
The Strategy
The strategy consists of two Roth options.
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 under Internal Revenue Code Section (IRC Sec.) 402(g), including catch-up contributions if eligible (age 50 or older). This deferral limit is $18,500 for 2018 and $19,000 for 2019, plus $6,000 catch-up each year.
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 is $55,000 for 2018 and $56,000 for 2019, 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.
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
While high income earners are fortunate to potentially have enough income to save well for retirement, if their income is too high, they won’t be eligible for annual contributions to Roth IRAs. That doesn’t mean they need to 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 Rollover
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 then 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.
