I don’t hear about new ideas very often, but here is one that a few people might find very useful. I call it the “Mega Backdoor Roth IRA.” There are several variations. Two of them work well for selected people, but after discussing the third with several retirement plan experts, it probably isn’t a viable option.
Prior to getting into the variations, I need to point out that most physicians and most Americans probably don’t want, don’t need, or can’t have a Mega Backdoor Roth IRA. An employee without the ability to contribute after-tax (not Roth) money to their 401K can’t have one. A typical physician not maxing out his 401K and other tax-deferred options is probably better off with more tax-deferred space rather than more Roth space. A regular old boring Backdoor Roth IRA will allow most docs to have some tax diversification in retirement. A practice owner with multiple employees probably can’t do a Mega Backdoor Roth IRA (the original impetus behind writing this post) due to profit-sharing laws. So who should consider doing a Mega Backdoor Roth IRA? Three people. First, an employee with a very unique 401K. Second, an independent contractor physician with no employees who needs more Roth space and is willing to give up tax-deferred space to get it. Third, a very high-income physician who expects to still be well into the top bracket in retirement (i.e. his effective tax rate on tax-deferred accounts is very similar to his marginal tax rate during his working years.)
Variation # 1 – The employee with a unique 401K
Some 401Ks not only permit $17.5K of either tax-deferred or Roth contributions, but ALSO permit you to contribute your own, after-tax money into the plan up to the $52K limit. A good example of this is the TSP for deployed military doctors. It isn’t a particularly good deal to just contribute after-tax money, UNLESS you can then get that money out and convert it to a Roth. Voila- A Mega Backdoor Roth IRA. Instead of only being able to contribute $5.5K per year, all of a sudden you can contribute $34.5K (plus the $5.5K in your personal and $5.5K in your spousal IRA.) If you’re over 50 and put your first $23K (remember the $5.5K catch-up contribution) into a Roth 401K, you could potentially put up to $65K per year into a Roth IRA. Here are the requirements:
- The plan must allow for after-tax contributions above and beyond the $17,500 employee contribution limit, preferably up to the $52,000 limit. So you can put in your $17,500 that is either tax-deferred or Roth, then contribute another $34,500 to the plan in after-tax dollars, similar to a non-deductible traditional IRA.
- The plan must allow for non-hardship in-service withdrawals of after-tax contributions.
- The plan should prohibit non-hardship in-service withdrawals of tax-deferred contributions (not mandatory, but a useful feature.)
- The plan should allow for “lump sum” contributions (not mandatory, but useful.)
Even if your plan doesn’t allow in-service withdrawals (like the TSP), if you are separating soon from the company (or military), you may be able to isolate that basis and accomplish the same thing like I did after I left the military. This is a great deal for someone who has limited tax-protected (and asset-protected) accounts but would like to save more for retirement. Unfortunately, most 401Ks don’t allow after-tax contributions. Check and see if yours does. Be sure the person you’re asking understands you’re not talking about Roth contributions, but contributions above and beyond the $17,500 limit.
Variation # 2 The High Income Independent Contractor
I usually recommend that a self-employed physician use an Individual 401K instead of a SEP-IRA. This is because you can max out an Individual 401K on less money, and 401K money isn’t counted in the pro-rata calculation you must do when doing a regular old Backdoor Roth IRA. However, if you wish to do the Mega Backdoor Roth IRA, a SEP-IRA is probably the best option, since I don’t know of an Individual 401K that allows both after-tax contributions and in-service withdrawals, although I wouldn’t be surprised to see one that allowed in plan conversions, which are essentially the same thing. Typically, the person doing this is going to have a very high income, far higher than the average doctor, and would prefer Roth contributions to tax-deferred contributions.
Here is how it works.
- Contribute your $52K to a SEP-IRA like usual. You can make this contribution anytime between January 1 of the current year and April 15 of the next year.
- Convert your entire SEP-IRA to a Roth IRA. On your taxes, you’ll deduct your SEP-IRA contributions, then pay tax on the conversion, but the net effect will be like contributing $52K to a Roth IRA. Be sure that you do your conversion prior to December 31st, as you do not want any money in the SEP-IRA on December 31st, lest you screw up the pro-rata calculation for your additional Backdoor Roth IRA.
- If you are concerned about the Step Doctrine, wait a few months between contribution and conversion. The tax burden won’t be that much higher and it won’t be that much more complicated.
Variation # 3 The Practice Owner’s Uniquely Structured 401K
I’ve heard from a couple of people on this one, and the consensus seems to be that it is illegal, although if someone has some information showing that isn’t true, I know some people who would be very interested.
The practice owner starts a 401K structured just like the one in variation # 1. However, instead of an employee, you are now the owner and responsible for the match and any profit-sharing contributions due to your employees.
You take these steps:
- Max out the employee contribution ($17,500) in either a Roth or traditional tax-deferred manner.
- Then contribute another $34,500 as a lump sum.
- Next, do an in-service rollover/transfer of the after-tax money to a traditional IRA. If the plan is written properly, you do not, and in fact cannot, withdraw the tax-deferred employee contribution. It stays behind in the 401K.
- Finally, convert the entire traditional IRA to a Roth IRA. This works just like the Backdoor Roth IRA, and you need to make sure you do not have any other traditional IRA, SEP-IRA, SIMPLE IRA money as of December 31st of that year. If you transfer directly to a Roth IRA (now allowed), then you can even have traditional/SEP/SIMPLE IRA money on the side.
When completed, you end up with $17,500 in the 401K and $34,500 in a Roth IRA. This allows you to tax-protect and asset-protect just as much money (more on an after-tax basis) as you would with a profit-sharing plan ($52,000 per year, more if you’re over 50). The point of this plan is to save on any profit-sharing contributions you would have to make for your employees, (a significant expense for a practice owner employing nurses, mid-levels, or other doctors,) although you would still be required to pay for plan expenses and any regular 401K matching contributions. Of course, the employees may not be very appreciative of that, so you might not want to mention it. At any rate, I don’t know of any retirement plan administrators willing to set up a small practice 401K into which the owner can make after-tax “employee” contributions, so it isn’t much of an issue any way.
What do you think? Do you use a Mega Backdoor Roth IRA? Would it be useful to you? Comment below!