Mega Backdoor Roth, Part Two: Is the Mega Backdoor Roth Strategy Right for Me?
NRAT contributions can be extremely beneficial. This article explores whether they’re right for you.
In Part One of this series, we discussed what Non-Roth After-Tax (NRAT) contributions are, how they work, and how they differ from other retirement account strategies. If you haven’t read Part One, I’d encourage you to do so, as much of the terminology and information in this article references points made in that one. Otherwise, let’s dive further down the NRAT rabbit hole.
Depending on the specifics of your employer’s 401(k) plan (which you can access anytime by referencing the Summary Plan Description, or SPD), Mega Backdoor Roths via NRATs offer a ton of upside. So, you might be asking, “If NRATs are so great, why wouldn’t every company offer them?”
As usual, it all comes down to cost.
Discrimination Testing
For employers to offer NRAT strategies — especially in-service withdrawals — the 401(k) plan must meet certain discrimination testing requirements. In the most basic terms, this means that the tax benefits of the plan cannot disproportionately benefit highly compensated employees (HCEs) or key employees, such as owners — at least not to the extreme. Allowing lower-level employees to make NRAT contributions makes it harder to pass these tests.
Why? Because the most highly paid employees tend to have the most disposable income and can therefore more easily use NRATs to exceed the normal $19,500 annual contribution limit. It goes without saying that a recent college graduate making $50,000 a year can’t save as much as an executive making $1 million a year. The IRS and the Employee Retirement Income Security Act (ERISA) require that 401(k) plans pass discrimination tests on an annual basis to ensure the plan is not disenfranchising rank-and-file employees.
That’s why NRATs are most common at large tech companies. Flush with cash, these companies offer higher salaries across the board, thereby employing a higher percentage of people who can afford to save. They also tend to be very generous with employer contributions, making it easier to pass discrimination testing requirements.
Understanding that only certain companies permit NRAT contributions, let’s look at a couple examples of people who stand to benefit from them.
Strong NRAT Candidates
Example 1: Morgan, early 30s
Morgan just turned 32. She grew up in a working-class family in the Midwest, then headed to NYC to work for a tech startup after college. She started in marketing with a modest salary and could barely afford to pay her rent, let alone make contributions to her 401(k). Fortunately, her company experienced massive growth. Morgan was promoted and received Incentive Stock Options (ISOs) along the way. When the company went public recently, Morgan was suddenly worth more (at least on paper) than she could have ever imagined.
Now, Morgan is thinking that it might be time to do something else with her life — extended travel, a career switch, or moving back home to the Midwest to start a family. She doesn’t see herself at this company too much longer. She wants to hand in her resignation letter on her 35th birthday, about three years from now.
Morgan’s only hesitation is that she feels behind on retirement savings. She wants to sell some of her company stock so she can diversify while also shifting the money into a tax-deferred vehicle. Fortunately, the company 401(k) recently began offering non-Roth after-tax “NRAT” contributions. Thanks to the recent IPO, Morgan has enough cash on hand to take full advantage of this strategy.
Morgan’s annual salary is $200,000, and she already contributes $19,500 to her 401(k). In addition, the company provides $5,000 to all employees with “no strings attached” to help comply with discrimination testing — for a combined $24,500. But she wants to save much more.
Good news, and more good news. Not only is she able to make $33,500* of NRAT contributions, but her plan allows her to utilize an in-service conversion. Over three years, this will add over $100,000** into her “Pure Roth” balance, money Morgan will never pay taxes on again.***
*$58,000 less $19,500 less $5,000 = $33,500
**$33,500 over three years = $100,500 (rounded to $100,000)
***Please note that the law could change. If you’d like to hear my thoughts on the future taxation of Roth IRA and Roth 401(k) accounts, please email me.
Why does Morgan’s plan work? For a few key reasons:
She has a high level of liquidity. Because of her company’s IPO and her long tenure at the company, she is doing quite well. The majority of her equity awards are vested and she has the ability to sell them.
Her company allows in-plan Roth conversions. This gives her a great deal of flexibility over the next few years and beyond.
Even if she didn’t have the in-plan Roth conversion option, it would probably still make sense. Why? Because she plans to leave her job fairly soon and would be able to get these dollars into a Roth IRA upon her departure from the company.
Now, if you’re low on liquidity or saving for another financial goal — a home, a car, paying down student loans — this strategy probably isn’t for you. If you have a significant amount of ISOs or RSUs and expect liquidity in the relatively near term, then you should review your SPD to see if NRATs are an option. However, if your plan allows NRATs but doesn’t provide much flexibility to “purify” the contributions (i.e. in-plan Roth conversions, in-service withdrawals), then this strategy must be analyzed very carefully.
Example 2: Ted, late 20s
Ted works as a software engineer for another large tech company. He’s in his late 20s. When he was 18, he moved from Kentucky to NYC for school, and decided to stay after graduation. Ted just got engaged and plans to move out of Brooklyn to a house in Westchester County in about two years.
Ted is a very healthy saver and he loves his job. He plans to continue working for the same company for the rest of his career. His fiancé is a teacher who expects to scale back on work when they start a family.
Like Morgan, Ted’s salary is $200,000. Also like Morgan, part of his compensation comes in the form of equity awards. He’s already making $19,500 worth of yearly Roth contributions to his 401k. His employer’s 401(k) works a little differently and instead matches his contributions up to 6% of his salary — adding another $12,000 to his account. This means he can make $26,500 of NRAT contributions if his plan allows for it.
Ted has a good bit of liquidity thanks to a large grant of Restricted Stock Units (RSUs) and a frugal lifestyle. He likes the idea of the Mega Backdoor Roth for its tax benefits, but his RSUs haven’t vested yet, and while he’s bullish on the company, he knows the stock value could decline. He’s also very serious about buying a house in Westchester and wants to be sure he has enough cash on hand when the right house speaks to him. Maybe most importantly, he wants to ensure that as his family grows, his fiancé can afford to stop working and devote her attention to motherhood.
By reviewing Ted’s SPD, we determine that his employer permits NRAT contributions. They do not allow in-plan Roth conversions, but they do permit $10,000 per year of non-hardship in-service withdrawals.
Because Ted isn’t planning on leaving his company, and because he wants to buy a home, it doesn’t make sense for him to fully maximize after-tax 401(k) contributions. So, we strike a balance: Make $10,000 worth of yearly NRAT contributions, transfer them to a Roth IRA, and save the remaining $16,500 outside of his retirement account.
In addition, we are going to switch Ted’s $19,500 annual deferral from Roth to Pre-Tax. Reason being, he expects to be in the 32% Federal bracket next year because a large portion of RSUs will vest. Between that and his SALT (New York State and NYC), his $19,500 contributions receive a 42%+ tax deduction.
Again, Ted isn’t the ideal NRAT candidate because his liquidity isn’t tremendous and he has upcoming changes in his life. On top of that, his plan does not allow for in-plan Roth conversions. But he can partially leverage NRAT contributions because of his company’s flexible in-service withdrawal policy while also taking advantage of the benefits of making $19,500 of pre-tax contributions.
Ted expects to be living in Westchester, married filing jointly, and in a lower overall tax bracket three or so years from now. At that point, we will revisit what combination of contribution types (Pre-Tax, Pure Roth, NRAT) make the most sense for him.
Conclusion
As you can see, many different factors influence whether or not — and if so, how much — you should take advantage of NRAT contributions.
For eligible, well-positioned candidates, Roth conversion strategies make a lot of sense…for now. Congress is likely poised to set further limits on these strategies, possibly including eliminating them altogether. If you think Roth conversion might be for you, reach out to your financial advisor as soon as you can.
I help many of my clients leverage Roth conversion strategies. Going it alone can be intimidating, but working with a professional clarifies and simplifies the process. If you’d like to learn more, please schedule a free discovery session today.
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