What Is a Mega Backdoor Roth Single(k)®?
Ubiquity’s Single(k)® plan is a solo 401(k) retirement plan designed to meet the needs of owner-only businesses.
This plan is designed for those who are self-employed entrepreneurs who have chosen to run sole proprietorships instead of working for large companies with HR and Benefits departments.
The Mega Roth option in Ubiquity’s Single(k) is designed to optimize your savings with after-tax contributions, not to be confused with Roth contributions. This product allows business owners who are already maximizing their savings through participation in a 401(k) plan, to make additional after-tax contributions.
How does it work?
In a standard solo(k) plan, you can only contribute the 401(k) limit, plus up to 25% of your pre-tax income via profit-sharing.
For business owners with lower incomes, this may not amount to the maximum 2024 limit of $69,000.
In the example above Julia’s annual earnings are $100,000 – 25% of this is $25,000, which is the maximum she can allocate to profit-sharing contributions.
By adding a Mega Backdoor Roth option to her Ubiquity Single(k), Julia can maximize by making an after tax contribution each year without being restricted to the 25% limit. Once funded, she can convert her after-tax amounts to Roth within the Single(k) plan.
Bottom line: Julia, brings her overall 2024 contribution to the $69,000 annual IRS maximum.
Understanding Contribution Types
To understand how the Mega Backdoor Roth strategy works, it’s important to understand some background information about 401(k) contributions. When you put money into a 401(k) as an individual, there are three different types of contributions you can make.
Pre-Tax Contributions
In a traditional 401(k), your contributions are made pre-tax. This means contributions come out of your paycheck before taxes and grow in your account tax deferred. Then you withdraw your money at retirement, your distributions are taxable to you.
The limit on the amount of pre-tax 401(k) contributions you can make in 2024 is $23,000.
Note: If you, as the employer, match a portion of your contributions, these contributions are also pre-tax but do not affect the $23,000 annual personal limit.
Roth Contributions
Roth 401(k) plans allow business owners and participating employees to pay taxes on their individual contributions now instead of paying taxes at retirement. Unlike traditional pre-tax 401(k) contributions, Roth contributions are made with after-tax money and grow tax-free through the time of withdrawal. When you reach retirement age (or meet other distributable events), your Roth contributions and attributable and earnings can be withdrawn tax-free.
After-Tax Contributions
The least-known type of 401(k) contribution is an after-tax contribution. After-tax contributions are not to be confused with Roth contributions.
After-tax contributions are made with money you’ve already paid tax on (similar to Roth contributions) and grow tax deferred.
The total 401(k) contribution limit for 2024 is $69,000 so to figure out how much in after-tax contributions you could make, simply subtract your personal pre-tax/Roth contributions and any employer contributions from $69,000.
For example, if someone maxes out their 401(k) in 2024 and their employer contributes $10,000, their after-tax contribution limit would be $69,000–$23,000–$10,000= $36,000.
Converting After-Tax to Roth
According to the IRS, after-tax contributions can be directly converted to Roth via in-plan Roth conversions or rollover to a Roth IRA, without paying any taxes. The Mega Backdoor Roth strategy takes advantage of this loophole.
Once you’ve made your non-Roth after-tax contributions to a 401(k) plan, if your 401(k) plan allows for in-plan-Roth rollovers, you can convert these monies to Roth so they may grow tax free. Any earnings you accrued on your after-tax contributions prior to converting to Roth, are considered taxable when you eventually withdraw those amounts from the plan or IRA account.
Mega Backdoor Roth Example #1
Taylor is 55 years old and allocates the maximum contribution of $23,000 plus the over-50 catch-up to her 401(k) for a total of $30,500. Taylor’s kids are out of college this year and she is able to use the additional cash flow towards her retirement savings. Taylor would like to fund a Roth because she wants her retirement income coming out tax-free, unlike her traditional 401(k) plan, where her income will be taxable upon withdrawal. However, Taylor is not permitted to directly fund a Roth IRA because her income is too high.
With the Mega Backdoor Roth strategy, Taylor is able to save an additional $46,000 in after-tax contributions in the same 401(k) plan because there are no income limitations with funding after-tax contributions in a 401(k) plan.
How the strategy works: With this $46,000 after-tax contribution, Taylor is able to move these funds into her Roth 401(k), creating an in-plan Roth conversion. Since the $46,000 was after-tax, this conversion has no tax implications. Now that these funds are labeled Roth, they will not be taxable upon withdrawal.
Taylor continues to do this each year for the next five years, building up her Roth. Had she only made direct contributions to a Roth IRA — assuming she qualified from an income standpoint — Taylor would have been subject to the annual maximum of $7,500 (the $6,500 limit plus $1,000 for being over 50). With Mega Backdoor Roth strategy, Taylor can contribute significantly more than what she could have saved in a Roth IRA on a yearly basis.
Fast forward to retirement, Taylor now has a pool of money in her Roth monies that she can access tax-free — unlike her traditional 401(k) plan. An additional benefit is that assuming she converts these funds to Roth IRA, they will not be subject to the required minimum distribution rules, meaning she is not forced to take her money out at 72.
Mega Backdoor Roth Example #2
John is 25 years old and allocates the maximum contribution of $23,000 to his 401(k) plan. John’s retirement strategy is to take advantage of saving early by maximizing his contributions while his expenses are relatively low.
John was considering an employer contribution but he only declares $75,000 annual salary. The 25% limit would cap his contribution at $18,750. Also, this contribution with growth would be taxable upon withdrawal. John doesn’t choose the employer contribution.
With the Mega Backdoor Roth strategy, John saves an additional $43,500 in after tax-contributions in the same 401(k) plan.
How the strategy works: With this $46,000 after-tax contribution, John moves these funds into his Roth 401(k) and now has a total of $69,000 in retirement plan monies. Since the $46,000 was after-tax, this conversion has no tax implications. With over 40 years left to compound, considering an average 6% return, John could potentially benefit from over $350,000 tax-free withdrawals in retirement.
John uses this strategy to maximize his Roth through his early 30s. By taking advantage of the Mega Backdoor Roth strategy, John reaches $5,000 for only 5 years, but with 6% annual return he could potentially reach almost $2,500,000 in after-tax monies at the time of retirement.
Is the Mega Back Door Roth Strategy for me?
If you are already contributing the maximum permissible amount to your 401(k) and want more out of your plan’s Roth capabilities, please check in with us to see if you can start making after-tax contributions as well. After-tax 401(k) contributions could allow you to optimize a long-term savings strategy.
