Roth 401(k)s have only recently gained traction with plan sponsors, despite the fact that both the Roth IRA and the 401(k) plan have been around for decades. As of 2018, according to the Callan Institute Defined Contribution Trends Survey, 85 percent of 401(k) plans now have a Roth option, up from 68 percent in 2016.

A Roth 401(k) can be advantageous for your 401(k) clients for several reasons:

• It offers the potential for tax-free earnings if the requirements for a "qualified" withdrawal are met.

• Its contribution limits are higher than those of Roth IRAs.

• Unlike a Roth IRA, it has no income phaseout limits.

For many high-income individuals, however, these benefits are attractive but often elusive. The funding limits of Roth 401(k) plans, while higher than those of Roth IRAs, still leave a lot of money on the table, and the income restrictions of Roth IRAs have led many to assume that this tax-advantaged savings option is out of reach. What these individuals may not know—and what you can demonstrate for them—is that 401(k) plans with an after-tax contribution feature present participants with a unique opportunity to both maximize savings and fund a Roth, if you employ the right strategies.

The Mega Backdoor Roth

The maximum amount individuals younger than age 50 can contribute to a 401(k) plan, including the Roth option, is $19,000 in 2019, which means high-income individuals could max out quickly. Retirement plans that offer an after-tax source (which is different from a Roth option), however, may accept contributions up to the IRS 415 limit of $56,000, excluding catch-up contributions. This means an after-tax source could allow for additional after-tax 401(k) contributions up to $37,000, assuming no employer contributions. In other words, investors can max out their 401(k) with after-tax contributions up to the overall contribution limit each year. These after-tax contributions made to the plan create a nontaxable “basis” that can be converted to a Roth IRA.

In Notice 2014-54, the IRS clarified that after-tax (not Roth) distributions from a 401(k) plan containing basis and tax-deferred earnings can be sent to two different destinations: the basis can be sent directly to a Roth IRA, and the tax-deferred earnings can go to a traditional IRA without triggering a taxable event.

How does it work? First, the plan must offer an after-tax source. For active employees, it also must allow participants to take in-service nonhardship withdrawals while still employed.

Next, the participant must determine how much to contribute to the after-tax bucket. The plan may restrict the amount of after-tax contributions participants can make to the plan because of top-heavy tests.

If a participant is eligible for an in-service withdrawal or has separated from service, he or she will need to instruct the plan administrator to cut two rollover checks: one for all pretax money to be directly rolled over to a traditional IRA and a second for after-tax portions to be transferred to a Roth IRA.

Who is it for? The mega backdoor Roth is for retirement plan participants whose plan offers an after-tax component. For high-income earners, it’s a way to further maximize retirement savings and leverage a tax-advantaged savings option to which they otherwise would not have access. For plans that do not have an after-tax component, talk to the employers, as adding this feature is another way for them to attract and retain top talent.

If the plan does not offer an in-service withdrawal option, the strategy could be executed once the participant is eligible to receive a distribution upon separation from service.

Why should advisors look for opportunities? In addition to enhancing the client’s options for saving for retirement, this strategy could lead to other fruitful planning discussions. For advisors who are helping their clients with wealth management but may not be the retirement plan’s advisor, the after-tax strategy is another idea you can bring to the table to further solidify client relationships. In each case, remember to evaluate the benefits of leaving assets in an employer plan versus moving them to an IRA.

In-Plan Roth Conversions

If the retirement plan and recordkeeper permit, participants can convert their pretax 401(k) contributions to Roth 401(k) assets while keeping the money in the plan. This strategy is similar to converting a traditional IRA to a Roth IRA. An in-plan Roth conversion can also be used to convert a participant’s after-tax source to a Roth 401(k) within the plan.

Unlike the mega backdoor Roth, however, part of the in-plan conversion of a participant’s after-tax source may be taxable. Because participants cannot cherry-pick their after-tax basis, the in-plan conversion may include earnings on after-tax contributions, which will be taxable when converted within the plan.

How does it work? In effect, participants redesignate the money in their pretax 401(k) or after-tax source into Roth money while keeping it in the 401(k) plan. Participants are not required to convert all their pretax money. They are, however, required to pay the income tax on any pretax amount they convert up front in exchange for the ability to have future earnings grow tax free in the Roth 401(k).

Although the money never leaves the plan, the recordkeeper or third-party administrator for the plan will issue a Form 1099 based on the conversion amount. Once the money is in the Roth 401(k) source, it can be rolled directly to a Roth IRA once the participant is eligible to roll money out of the plan.

Who is it for? The in-plan conversion option could appeal to high-net-worth individuals who may not need their 401(k) money at retirement. These are savers who would rather grow their qualified plan assets as an income tax-free inheritance for their spouse or children. For them, the tax they’ll have to pay at the time of conversion may be worth the long-term growth potential of an account that won’t have additional tax consequences.

Why should advisors look for opportunities? Once pretax 401(k) balances are converted to a Roth 401(k), future earnings grow tax free. As a result, the younger the participants are, the more years of tax-free compounding they’ll experience. When plan participants leave their employer, they can roll over the Roth 401(k) to a Roth IRA. And, both owners and spouse beneficiaries will benefit from not having to take RMDs from their Roth IRA. (Keep in mind, though, that nonspouse beneficiaries of inherited Roth IRAs may be subject to RMDs.)

Helping Clients Understand Their Options

High-income earners’ ability to establish a Roth IRA is something that many advisors and plan participants may not be aware of. In-plan Roth conversions and the mega backdoor strategy could help your 401(k) clients maximize the amount they save for retirement while also realizing tax-free earnings. They’re yet another way you can demonstrate your expertise and add value for your clients.

Commonwealth Financal Network® does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.