This post is an explanation of the opportunity to create a mega backdoor Roth IRA from a 401(k) account. This technique can allow someone to potentially add over $25,000 per year to a Roth IRA without any income limits. This post can be used as a guide for any participant in a 401(k) plan that has the features for the transaction that has become known as a mega backdoor Roth contribution, but this post is specifically geared for employees of Sprint Corporation.
I’ll warn you upfront, that I broke out my inner nerd in writing this article. The topic is complex enough that to thoroughly cover it, the article became a little lengthy. If you get the gist of the topic, and want to explore it further without wading through all the details on your own, just send me an email and I’ll try to clear up any questions you might have and point you in the right direction.
How This Guide Can Help You
I often get asked how someone can put more money into retirement accounts and lower their taxes in retirement. Many individuals wish to contribute more to their company’s 401(k) plan but are limited to pre-tax contributions of $18,000 per year ($24,000 if over age 50). Roth IRA contributions are limited to $5,500 ($6,500 if over age 50), and if an individual has adjusted gross income over $118,000 or if a married couple has AGI over $186,000, the allowed contributions are quickly phased out to zero.
However, there is a little known method of making annual contributions of potentially $25,000 or more into a Roth IRA, with no limits on income. This can lead to a sizable tax-free bucket of money that can then be used as a tool to manage (lower) taxes in retirement, thereby increasing spendable cash flow.
What’s Covered in This Guide
This guide is meant to be written in plain-English, be as short as feasibly possible, and not go down the rabbit hole of discussing an endless array of retirement plan, tax, and IRS rules.
I’ll be covering:
The background for Backdoor Roth IRAs
The Mega Backdoor Roth IRA
Procedures for employees of Sprint Corporation to utilize the Mega Backdoor Roth
If you’re a first time visitor to my website or don’t know much about me, I am a Certified Financial Planner™ professional who has been in the financial advisory industry for 20 years. I’m an independent advisor not affiliated with any of the Wall Street firms or big banks, and I have no connection with the Sprint Corp 401(k) plan. I do reside in the same metropolitan area as its headquarters, and this has helped me gain some of the insight to the plan that I’ll share.
Before I go any further, let me throw out the typical disclosure/legal mumbo jumbo for CYA purposes:
This is a general review and should not be interpreted as a specific recommendation for anyone. Neither Sprint Corporation nor its 401(k) provider have endorsed this article in any way. I am unaffiliated with Sprint Corporation and its 401(k) provider and do not receive compensation for this article. There is always the possibility that Congress and the IRS will change tax laws or their interpretation of them in the future, which could lead to less desired outcomes for individuals. In some situations it might be better for an individual to leave money in a work related retirement plan than roll it into an IRA. An analysis of the pros and cons of leaving money in a 401(k) or rolling it to an IRA should be conducted prior to pulling the trigger on any transaction. Before pursuing any strategies described here, discuss them with your tax professional.
The Background for Backdoor Roth IRAs
Roth vs. Traditional
As you probably know if you’re reading this, money in a Traditional 401(k) or a Traditional IRA gets a tax deduction going in and any gains are tax-deferred while the money is in the account. When you pull money out, normal taxes apply. Roth 401(k) and Roth IRA accounts work in the opposite manner. The dollars going into the accounts have already been taxed. Any gains are tax-deferred, and as long as you meet the age and holding period requirements when you withdraw money, the gains are tax-free.
If your tax rates are constant, then the net after-tax proceeds from withdrawals from the accounts are the same. That being said, many people assume that tax rates will increase over time because the government has an unsustainable debt level and Social Security and Medicare will need extra tax dollars to pay for the retiring baby boomers. So if tax rates increase in the future, paying the lower rate today is a better deal. Also, if you have a bucket of tax free dollars in retirement you can use that to manage your taxable income. This could potentially allow you to pay lower taxes on your Social Security for a few years and the tax savings could be used as an extra travel budget or saved to increase your money’s longevity.
Roth Income Limits
As I mentioned above, individuals or households pulling down an income in the low six figures are not allowed to contribute to Roth IRAs because “they make too much money”. And people that are within the income limits and want to save can only contribute a little over $5,000 per year.
Backdoor Roth via Nondeductible IRA Conversion
There is a method to put money into a Roth IRA in a convoluted manner by making non-deductible contributions to an IRA and then converting that money to a Roth IRA. However, there are three problems with this approach. First, the small contribution limits still apply.
Second, if you have any money in a Traditional IRA that was contributed pre-tax (which it most likely was), then any amount that you convert from the non-deductible contribution is counted in a pro-rata proportion to the value of ALL of your IRAs. For example, if you have $95,000 in a pre-tax Traditional IRA and make a $5,000 non-deductible Traditional IRA contribution and then want to convert that $5,000 to a Roth IRA, you’re going to be stuck. That’s because the non-deductible percentage of all your IRA money is only 5%. ($5k out of $100k) The IRS says that if you are going to convert IRA money, each dollar converted is a pro-rata amount of pre-tax and after-tax money. So on the $5,000 conversion, only 5% of it, or $250, would count as being after-tax money. That means that you’d own taxes on the other $4,750.
Lastly, there are differing opinions by tax professionals on whether or not this method falls into a type of transaction that is not allowed. There isn’t any ironclad guidance, and most tax professionals seem to be of the opinion that as long as there is a time lag between making the contribution and processing the conversion, that it’s fine. But who wants to screw around with the IRS? The Mega Backdoor Roth doesn’t have these problems.
The Mega Backdoor Roth Opportunity
In all my years as a financial planner, this is the biggest and best virtually unknown financial planning trick I’ve seen. Yes, it’s been given a ridiculous name, but it’s the real deal. It can allow you to funnel potentially over $25,000 per year into a Roth IRA regardless of how much money you make.
How It Works
To fully explain this, I’ll need to give a quick primer on 401(k) contribution rules. The employee tax-deductible contribution limits for 401(k) plans are $18,000 per year ($24,000 if over age 50). Technically, this figure could be a little lower if you’re a high earner and your company has to lower the maximums for the bigger earners to keep the whole plan in line with the rules. But either way, $18-24k is the most allowed. Of course, most companies provide a company matching contribution. The combined maximum contributions from you and your employer are limited to $54,000 per year. And the amount of the percentage match can’t be applied to any more than $270,000 in wages. So for most people, the combined maximum contributions are going to fall well below the $54,000 figure.
For example, say someone makes $150,000, contributes $18,000 to the plan, and their company matches 50 cents on the dollar up to the first 6% of contributions. That match effectively works out to 3% on the $150,000, or $4,500. So the total going into the plan is $22,500. ($18k from the employee and $4,500 from the company.) Since technically $54,000 is allowed to go into the plan, this means that $31,500 of potential contributions aren’t being made.
Some 401(k) plans let the employee top off the total contribution limit with after-tax contributions. So in the example above, after contributing $18,000 before taxes, the employee could contribute an additional $31,500 after-taxes.
The after-tax contributions grow tax-deferred just like the other contributions. However, they’re segregated so that when you withdraw money, you won’t have to pay any taxes on the money that’s already been taxed. Some sharp plan administrators have structured their companies’ 401(k) plans to allow for distributions of the post-tax contributions even while the employee is still working at the company. These distributions can be rolled over to a Roth IRA. This is how you are able to funnel roughly five times the annual Roth IRA contribution limit into a Roth, even if your income is high enough to prevent a regular contribution.
If the post-tax portion of the 401(k) has made money from the mutual funds that it’s invested in, the profit portion of the account will be taxed when the rollover is done. Alternatively, some plans will issue a separate check for the profit portion, and this check can be rolled over into a Traditional IRA, thereby continuing the tax deferral and avoiding a taxable event. In practice, most people implementing this strategy roll over the post-tax contributions shortly after making them, which makes it unlikely that there are any meaningful profits yet. Also, they can choose to keep the contributions invested in the plan’s money market until they complete the rollover, which would make any profit negligible. Even if a plan doesn’t allow for two checks which would allow for the profits to be rolled into a Traditional IRA, paying a little bit in taxes (on an investment profit, not an extra tax on the contribution amount) should be an irrelevant factor in the decision making process.
Sprint Corp. 401(k) Plan Allows for a Mega Backdoor Roth
Sprint’s retirement plan is structured to allow employees to top off their 401(k) account’s maximum contribution limit with after-tax dollars AND the plan lets them roll over those post-tax contributions into a personal Roth IRA account even when they are still employed at the company.
Sprint isn’t alone in having this type of plan structure. It has become a feature in several Silicon Valley company plans like those offered by Google and Facebook. However, the availability of this feature typically isn’t touted by companies. I think there are a few reasons for this lack of awareness. First off, this type of transaction isn’t something that was expressly planned for the overall 401(k) structure. It’s not like the basic features of tax deferred contributions, an employer match, etc. It’s more of a technical feature that evolved with the formation of Roth IRAs. Second, with the average American household income somewhere around $50,000, most people aren’t able to max out their own $18 – 24k contribution, let alone “top it off” with another $20 – 30k+ of after-tax contributions. So touting this feature wouldn’t do a lot for company morale. Possibly the biggest reason though, is that even though someone or some group that set up the plan probably knew about the feature, many or even most of the employees at any given company whose job duties include working with the plan might not even realize that the opportunity exists.
Geeky Reference for Verification
For those of you (like me) that want to verify everything before making a decision, here’s the IRS information that you can Google to read about how the tax treatment of this type of distribution is legit: IRS Notice 2014-54.
How to Get a Mega Backdoor Roth from a Sprint 401(k) Plan
The steps for a Sprint employee to take advantage of this opportunity are fairly simple. First off, you need to make sure that you’ve maxed out your pre-tax contributions of $18,000 or $24,000 if you’re age 50+. Then you need to make additional contributions that will be with after-tax salary dollars. If you are fortunate enough to get a sizable bonus most years, then you could fund this topping-off contribution by increasing your 401(k) contribution withholding for the payroll cycle of when you get paid the bonus. This way, you might be able to top off the account all at once and then quickly roll it over to knock out the whole procedure in a short amount of time.
Before you contact the 401(k) provider to initiate the rollover, you’ll need to have a Roth IRA account set up somewhere. For a shameless plug, my financial planning practice utilizes some of the big name, low cost IRA custodians, so we could help you on this front. Once you have the right account set up, you’ll need to call the 401(k) provider and tell them what you’d like to accomplish. They are familiar with this type of transaction, so tell them that the rollover you’re wanting to have processed is for the type of transaction that is sometimes called the mega backdoor Roth. As when talking to any customer service call desk, sometimes things go more smoothly with certain people than with others, so if you’d like some help, I or one of my associates could be on the line with you when you make the call.
Your rollover check will be made payable to the IRA Custodian/Brokerage Firm FBO (for benefit of) Your Name. DON’T ENDORSE IT. Technically it’s made payable to the IRA account, you’re just the beneficial owner. Once you have the check, you’ll need to forward it on to your Roth IRA firm or financial advisor.
That’s it. Then the following year and every year after that, wash, rinse, and repeat. You’ll be on your way to building up a bucket of tax-fee money that can actually amount to something and give you added flexibility to manage your taxes in retirement.
Summary
There’s a legitimate way for workers at some companies to plug around five times the amount (approximately $25,000+) of a normal Roth IRA contribution into a Roth, even when their income exceeds the Roth limits.
This type of transaction is sometimes referred to as a Mega Backdoor Roth IRA.
Mega Backdoor Roth is a silly name.
Sprint Corporation has a 401(k) that allows for the Mega Backdoor Roth.
If you want to geek-out, you can read more about it on IRS Notice 2014-54.
WARNING
While I’ve tried to explain all this stuff in an easy-to-read manner, as with most financial topics, the devil is in the details and things can get complicated sort of fast. Just because you have access to something like this doesn’t mean that you should do it if there are other financial planning levers you could pull that would be more advantages. You’ll need to review how this type of transaction fits in with the rest of your financial picture to make sure you’re not shooting yourself in the foot. Better yet, just get in touch with me and I’ll be able to quickly let you know if you should put the brakes on the idea. It’s quite possible that some other low-hanging fruit might be better, at least for some of the incremental dollars that would be used.
Have Questions About Taking Advantage of the Mega Backdoor Roth Opportunity at Sprint?
If you have questions please let me know. You can reach me via my contact form here.
Funneling $25k+ a year into a tax-free Roth IRA could be a great way to ratchet up your retirement planning techniques to pursue an even greater retirement lifestyle.
If any of your coworkers might like to know about this opportunity or anyone else that might work at a company that could have a 401(k) with this feature, please share this post with them. I’m always getting asked how people can take advantage of all the opportunities that exist to bump up their retirement savings and minimize their taxes. And the “Mega Backdoor Roth” is one of the most under-the-radar planning techniques I’ve seen. Just click on the little “share” button to share this article. That way your friends will have an extra tool at their disposal to possibly help make their retirement better.
Thanks for reading this rather long, technical post. I hope it made sense and that you found it beneficial.
To a Better Retirement,
Ryan Poage
