[Editor’s Note: Today’s guest post is from Konstantin Litovsky, a long-time WCI partner and an expert in designing low-cost small practice retirement plans.]
Much of the information available on the internet and on WCI covers individual or ‘solo’ 401(k) plans. Not a lot is written about Employee Retirement Income Security Act (ERISA) 401(k) plans where in addition to owners (who are highly compensated employees, or HCEs) there are also non-highly compensated employees (NHCEs). Most plans that are not owner-run, such as those offered by hospitals, universities, and other large employers don’t allow the option for doing Mega Backdoor Roth conversions, but a smaller partner-run practice plan can easily adopt any changes necessary to implement the mega backdoor Roth 401(k) strategy.
ERISA vs. Non-ERISA 401(k)
ERISA 401(k) plans are covered under ERISA (Federal law) and while individual 401(k) plans are not covered under ERISA, they are still covered under both Federal and State law. There are several key differences between ERISA and non-ERISA 401(k) plans:
Protection for bankruptcy vs. creditors. ERISA assets are protected up to an unlimited amount from both bankruptcy and creditors. Individual 401(k) plans offer bankruptcy protection and will offer some protection from creditors depending on the State law. ERISA plans come with an additional compliance burden vs. individual 401(k) plans. As a result, there are some nuances when implementing mega backdoor Roth with ERISA plans. The biggest difference as it relates to mega backdoor Roth is that individual plans can be set up as needed for optimal mega backdoor Roth, while ERISA plans cannot always be customized for mega backdoor Roth due to plan design and demographics.
In this article, we’ll discuss how ERISA plans can implement mega backdoor Roth 401(k), as well as why mega backdoor Roth works for high-income doctors, and what some of the reasons are to consider it.
Why Roth IRA?
Roth IRA distribution is not taxable under current tax rules, and this is unlikely to change in the future. Roth allows tax-free accumulation and withdrawals, which is especially valuable for high-earning doctors due to the uncertainty related to future tax laws and the real possibility that taxes will be increased over time. Because many WCI readers are in the top 1%, much of the conventional wisdom does not apply to them, so we need to develop a set of guidelines that can help those in the highest tax brackets make informed decisions regarding different retirement plan buckets, especially Roth.
#1 Retirement Tax Bracket Considerations
It is generally agreed that if you are in the highest tax brackets during your working years and expect to be in lower brackets in retirement, that the tax-deferred bucket is the most important one to maximize vs. Roth. This is because Roth presents a significant tax drag paid at a high average tax rate, which will eventually add up to the point where tax-deferred is a better long-term account vs. Roth. For those in the highest brackets, non-deductible Traditional IRA to Roth IRA conversion, or the ‘backdoor’ Roth, is a very popular option due to having no tax drag, albeit adding up to a relatively small amount.
There may be situations when your tax brackets will be the same or higher in retirement, and, in that case, maximizing Roth can be a good idea. This is not easy to forecast, so some degree of tax diversification will be advisable. For example, a Cash Balance plan might not seem very useful from a Roth standpoint, yet it is a good way to put a lot of money into a tax-deferred account that can be converted to Roth later on when you are in the lower tax brackets. We’ll discuss this in more detail below. Making bigger Roth contributions into a 401(k) plan might also work if you already have access to other accounts where you can get a tax deduction on your contributions (such as a Cash Balance plan, for example), and you can consider this as a form of tax diversification in case you don’t end up in a lower tax bracket in retirement.
#2 Required Minimum Distribution Planning Considerations
Even though these types of calculations can be quite involved and highly dependent on individual tax situations (as well as on multiple assumptions), in general we can say that those with a large tax-deferred portfolio ($3M and above) should rightly be concerned about RMD (required minimum distribution) taxes. RMDs start at 4% at age 72 and go up to as high as 11% at age 95. The big question is whether taking RMDs is better than the alternative, which is converting some or all of your tax-deferred portfolio to Roth. With Roth, your distributions are tax-free (and can be withdrawn 5 years after conversion), so what we need to determine is whether it is worth prepaying taxes to end up with a big Roth account or whether it is better to take RMDs and do nothing.
As an example, let’s consider someone who is retired at age 62 with a $5M tax-deferred portfolio, which is not that difficult to accumulate if you’ve participated in a 401(k) and a Cash Balance plan over the course of your career. Let’s assume that all of the taxes will be paid from a taxable account, that conversions are done over a 10-year period from age 62 to age 72, and that the life expectancy is age 95 (which is not unreasonable since the surviving spouse can carry on the Roth conversion strategy without interruptions). Let’s also assume that from age 62 to 95 we have a 4% return for the taxable account, 6% return for Traditional IRA/Roth IRA accounts, 2% inflation, and that all tax-deferred accounts will be converted to Roth at the end of the 10-year period. To cover expenses, $100k will be withdrawn from the taxable account each year, and Social Security of $34K for each spouse would be taken at age 70.
According to this retirement plan calculator offered by Wealth Trace, the net advantage of the Roth conversion strategy (from age 62 to age 95) is about $4.5M vs. taking RMDs and not doing any conversions. The average tax rates (from age 62 to age 95) are 20% and 15% respectively for the RMD and the Roth conversion strategy. Even though during the 10 years when conversions are made the tax rates are higher, they are much lower during subsequent years. On the other hand, RMD tax rates are much higher from age 85 to age 95. You are also going to pay about $2M in taxes during the 10-year conversion period, so this approach will require a sizeable taxable portfolio. Please note that the numbers can vary widely depending on retirement age, conversion period, starting portfolio, return assumptions, etc., so this example should not be used as a general rule, but rather as a starting point to discuss this strategy.
What happens if neither of the spouses lives to age 95? There is a breakeven point which would vary depending on all of the assumptions mentioned above, and it is likely to be in the early to middle 80s for most scenarios. Whether the breakeven point is reached or not, there is another important reason to consider Roth conversions in retirement.
#3 Estate Planning Considerations
The SECURE Act of 2019 eliminated the ‘stretch’ IRA, which was a key estate planning component for those with high tax-deferred portfolios, removing the ability to distribute IRA assets over the lifetime of IRA beneficiaries. Instead, IRA assets are now going to be distributed over 10 years, which can create a significant tax burden for the beneficiaries. Imagine a $5M IRA distributed over 10 years by a single beneficiary (non-spouse and non-minor). Each year as much as $500K has to be removed, catapulting the beneficiary into the 35% bracket. Moreover, if we assume a modest 4% return, this amount jumps to about $600K, and this will most likely put the beneficiary into the highest Federal and State brackets. In some states this can be as high as 50%, resulting in as much as 1/3 of this money disappearing due to taxes.
This might result in as much as $2M in taxes on $6M withdrawn over 10 years. As you can see, even if the IRA owner just breaks even on the conversion, they will give their beneficiary an additional $2M if instead of distributing a Traditional IRA over 10 years the beneficiary can distribute a Roth IRA.
Three Ways to Accumulate Roth Assets
Now that we’ve discussed several planning strategies using Roth, let’s talk about ways to build up a big Roth account during the accumulation phase if you don’t have access to an individual 401(k) plan. For the discussion below, it is assumed that the practice owners control the plan document and that appropriate amendments can be made to the plan document to allow in-plan Roth conversions, depending on the specific needs and demographics of the plan.
#1 Backdoor Roth IRA
This is the default approach for anyone who is phased out from contributing to Roth IRA directly. A non-deductible Traditional IRA contribution is made and converted to Roth immediately.
#2 Mega Backdoor Roth 401(k) – Version 1
Version one of the mega backdoor Roth 401(k) involves in-plan Roth conversion of after-tax voluntary employee contributions that can be made into a 401(k) plan. After-tax contribution can be converted to Roth inside the plan without having to move the money out (usually as soon as the contribution has been made). No tax is owed on this transaction. Total contribution can be made up to $58K in 2021 (maximum total contribution, employee and employer), and this is usually made as Roth 401(k) ($19,500) plus Safe Harbor (4% match or 3% non-elective contribution which is tax-deferred) and after-tax contribution (up to the maximum). While in principle it is possible to roll just the after-tax money out of the plan into a Roth IRA before reaching age 59 and ½ as an in-service distribution, you need to be careful because the IRS requires that money is rolled over pro-rata, so if there are any gains on after-tax contributions, these would have to be rolled over as well (and since the gains on after-tax contributions are taxable, the gains can be rolled to a Roth IRA, but you will need to pay all applicable taxes on this transaction). Moreover, your plan document has to specifically allow in-service distribution of after-tax money, so this can be a viable option if all of the rules are followed closely. If you’ve already converted after-tax to Roth inside the plan and you want to roll the converted amount to a Roth IRA, this can also be done as an in-service distribution. One important thing to note is that taxable gains converted to Roth inside the plan and gains accumulated after the conversion to Roth inside the plan are subject to the ‘5-year’ and ‘age 59 and ½’ rules once rolled over to a Roth IRA (one has to wait 5 years and be 59 and ½ to withdraw the gains, while the basis can be withdrawn immediately).
Version two of the mega backdoor Roth 401(k) involves in-plan Roth conversions of tax-deferred assets. Tax-deductible contributions to your 401(k) can be converted to Roth inside the plan (you specify the amount and timing). This can allow you to make strategic Roth conversions on demand. For example, when the market crashes, you can convert part of your portfolio to Roth at a discount. Conversion is made pro-rata—equal percentages are taken from all of your plan investments. In the version one plan, Safe Harbor match/contribution can be converted to Roth as well.
A note about converting both after-tax and tax-deferred assets to Roth. Some record-keepers (including Ascensus) can only track one source of Roth conversion, so if more than one source is used (including both after-tax and tax-deferred), the third-party administrator (TPA) has to make sure that this is tracked accurately.
Partner Only (HCEs) vs. Partners and Staff (NHCE) ERISA Plans with Partners and NHCE Staff
In the case of an ERISA plan with NHCE staff, after-tax is rarely if ever going to work unless your NHCE staff is making after-tax contributions, which they have no reason to make. This is because after-tax contributions have to pass the Actual Contribution Percentage (ACP) test that compares how much NHCEs are contributing vs. the HCEs, and if not enough NHCEs are contributing, then HCE contributions would be refunded (defeating the whole purpose for making them). As a result, solo and group practice plans with NHCEs can only do in-plan Roth conversions.
In-plan Roth conversions of tax-deferred contributions will produce exactly the same Roth account as when making Roth conversion of after-tax contributions. The only time this makes a difference is when you also have eligible qualified business income (QBI) that you want to maximize, in which case making after-tax contributions is preferable as that would preserve your QBI deduction. However, this only applies to businesses that get an unlimited QBI deduction regardless of income (known as ‘qualified’) vs. ‘specified’ businesses (including medical/dental) that are completely phased out after owner’s or partner’s taxable income on joint return reaches $421K (in 2021). For this reason, QBI is not an option for most partner-only group medical practices that will consider making after-tax contributions.
ERISA Plans with Partners Only
If your plan has only owners/partners and no NHCE staff, you can make after-tax contributions, and consequently make Roth conversions of both tax-deferred and after-tax contributions. One use of after-tax contributions would be in a 401(k) with a non-PBGC Cash Balance plan (with fewer than 25 participants) where profit sharing is limited to 6%. In this case, you can potentially contribute up to the maximum allowed ($58K in 2021) into the 401(k) using after-tax contributions, and convert those to Roth.
This can sometimes get tricky with partner-track doctors who are allowed to enter the plan immediately since they enter the plan as NHCEs during the first year (even if they make above HCE salary limit since day one). They are usually given a top-heavy minimum employer contribution (3% Safe Harbor contribution if there is only a 401(k), and additional 2% profit sharing if there are both 401(k) and CB plans), and if the doctor is not an HCE the following year (because they only worked part of the year and haven’t reached HCE maximum), they would have to be given an additional profit-sharing contribution.
In order for partners to make after-tax contributions themselves, partner-track doctors should make after-tax contributions as well, as discussed above (and usually they would be willing to do so). In the case of the top-heavy minimum, this calculation is rather straightforward (basically, making sure that together with the salary deferral and employer contribution, the after-tax contribution does not exceed the maximum allowed into the plan). However, in the case of NHCE doctors, the issue is that they do not know exactly what their employer contribution will be (as it is usually calculated the following year by the TPA), and in some cases it would be quite high, so this won’t leave much room for after-tax contributions, at least as long as they are NHCEs. Due to this issue, after-tax contributions have to be carefully planned especially if you have immediate eligibility for partner-track doctors.
Have you used an ERISA plan in your small practice? Why or why not? What has your experience been? Comment below!
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