Yet another Mega Backdoor Roth (solo 401k) question

[Robert]

Hoping someone can answer this for me.   I spent ~2-3 hours last night reading IRS pubs, letter and various websites but couldn’t seem to find the definitive answer. . . or maybe I did and just didn't understand it.

I’m a 56 year old, retired physician and have a part-time, self-employed job (S Corp) performing inspections. I make ~$50k per year. It keeps me busy, social and I only have to tap ~$30-40k/year from my non-qualified savings to live. The Mega Back Door option seemed like a great way for me to convert some of my non-qualified savings to a ROTH account. In fact, that is the only reason I’m thinking about doing this!   I’m just about ready to pull the trigger on setting up a Mega Back Door system. I’ll use Etrade for the custodial account. Ascensus for the plan doc (only IRS approved i401k doc wit after-tax contribs allowed I could find).

Here is my question: are after-tax contributions included in Section 415 limits?  For example, if my W2 compensation is $42000, can I still place $54k into the account? Am I limited to $42000 (my W2 income)?  How about the $6000 catch-up contribution?  It seems to me that is NOT subject to income limitations . . . but, then again, what do I know?!?

Thanks, hope someone knows the answer.

[PhysicianOnFIRE]

I don't think you need the Mega Backdoor. That's for employed people with 401(k)s who have maxed the employee contribution. With a solo 401(k), I would think you could just make Roth 401(k) contributions directly up to the limit based on your income.

[spiritrider]

Yes, after-tax contributions are subject to 415c limits. The catch-up contribution is not subject to 415c limits.

You would have to make $24K in employee deferrals to take advantage of the catch-up. Then you could make $42K - $18K = $24K in annual additions. The question is, where does the other $24K come from. Do you have enough additional net business profit to pay the $10.5K ($42K * 25%) employer contribution. That would leave $24K - $10.5K = $13.5K available for after-tax employee contributions. So the bottom line is that you could make $48K in contributions on $42K of W-2 wages.

Note: The employee share of FICA and income tax withholding would have to come out of the remaining W-2 wages ($42K - $24K - $13.5K = $4.5K). That really would require the employee deferral + catch-up  to be Roth.

[ReFinDoc]

I don't see the big whoop about funding Roth IRAs , especially at your age. Put your "non-qualified savings" into a low-fee, index fund in taxable account. Learn to TLH. I'll bet you can take off the LTCG at 0% tax every year. This is essentially the same as a tax-free Roth withdrawal. Money is fungible.You could put 24k+contribution into your  solo401k. Maybe start transferring your tax deferred stuff to a taxable account or Roth convert to decrease future RMDs. Always exploit the 15% tax bracket. Are you W-2 or 1099? I don't see the value of the s-corp with revenue so small. Accounting fees will be high.

Maximize your legitimate business expenses to pay less SE tax, then maximize your Above-the-Line deductions.  Do you have a HSA plus HDHP?

[jfoxcpacfp]

PhysicianOnFIRE wrote:

I don’t think you need the Mega Backdoor. That’s for employed people with 401(k)s who have maxed the employee contribution. With a solo 401(k), I would think you could just make Roth 401(k) contributions directly up to the limit based on your income.

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The difference is that the Mega is not limited to a percentage of earnings and can be dollar for dollar. The Roth 401k contribution w/max out at $18k plus 25% of salary.

[Robert]

spiritrider and Joanna Fox,

THANK YOU very much for the clarification.

spiritrider, apropos to your follow up question I confess that I'm a bit confused.   I have a feeling I lack some fundamental bit of knowledge. . . . I hadn't planned on making an employER contribution at all.  I only planned on making after-tax, employEE contributions to the 401k and follow that with an immediate in-service roll-over to a ROTH-IRA.  As far as I can see, it doesn't matter much if I contribute $24k to the ROTH 401k & $24k to the 401k or put it all in the 401k and transfer it to a ROTH IRA.  In fact, it seems simpler to do the latter.  So, using the above example, I would contribute $42k +$6K (all employee contributions) to my 401k.  All of these "contributions" would come from my taxable account.   I also make a ROTH IRA contrib from the same.

OK, here are some specifics about my situation:  IRA, $2900k balance; taxable brokerage account, $1300K.  My wages (I still pay myself via my S Corp and get a W2) and taxable account earnings cover my living expenses at present.  I don't plan on "saving" any additional money for retirement.

This strategy seemed like an opportunity for me to shuttle some of the money I have in my taxable account to a tax-advantaged ROTH for both tax and estate planning reasons.  There are not significant LTCG associated with the transactions (MUNI funds).   Being able to shelter ~$50-60K/year for another 5-10 years appeals to me.  Furthermore, it's not inconceivable that I might live another 40 years and the tax savings would not be insignificant.

[Robert]

ReFinDoc,

Thanks for taking the time to answer.

The S Corp adds $825/year cost.  I do my own bookkeeping and payroll.  I pay myself via W2.  Historically, I used the S Corp to fund my retirement because all contributions were employer contributions and not subject to any payroll tax (as a sole proprietor, I noticed they came off on my 1040).  I used to also pay myself for an unrelated business activity as a sole-proprietor.  By doing this separately from the corp, it conferred payroll tax benefits as well as allowing me to fund a second 401k.  The other reason I incorporated was per the advice of my ex-brother-in-law, a tax attorney.  He mentioned the odds of going through the hassle of an audit were almost nil if I incorporated.  Your point is well taken though.  I could liquidate the corp, save myself a few bucks and still do the Mega Roth.

I guess I wasn't clear in my original post as to why I'm doing this.  I'm not interested in making additional retirement savings.  It seemed like a legal way to "play a shell game" with the money I already have and move some into a ROTH vehicle, without taking a tax hit.   The tax advantages of such are my motivation.

[spiritrider]

You missed my point that the $6K employee catch-up contribution is actually a like an extra $6K employee deferral contribution. It can only occur after you have maximized the $18K employee deferral limit.

Only an employee catch-up contribution is not subject to the 415c 100% of compensation annual addition limit. With no employee catch-up contribution, your maximum annual addition limit is 100% of compensation ($42K).

The maximum employee after-tax contribution would be further restricted by the mandatory 7.65% employee share of FICA = $3,213. Your maximum employee after tax contribution would be $42K - $3,213 = $38,787.

This not that different than my $24K Roth + $13.5K = $37,500. In fact you probably could reduce the employer contribution by the difference $38,787 - $37,500 = $1,287 and increase the employee after-tax contribution by the same amount.

You would be able to rollover the Roth 401k to an Roth IRA >= 59 1/2. This would give you the same Roth IRA amount, but you would have the extra employer contribution that could be rolled over and converted to a Roth IRA if you so desired. Giving you ultimately $48K in the Roth IRA.

[Robert]

spiritrider,

Thank you, again, for a thoughtful response. The fog is starting to clear for me!

Have a simple plan now:  First, make an $18000 salary Roth deferral before I can add the $6000.  $24k into the Roth leaves $24k for after-tax contribs in the example above.  This explains the rationale for having the Roth 401k account as well.

If I follow your next point, it seems the theoretical maximum, after-tax contribution is not my total taxable wages (Box 1, W2) but taxable wages minus FICA (similar to net adjusted earnings calc for SEP-IRA contribs).  Thank you for pointing that out.  I don't think that limitation will affect me unless I work half a year.  I would have messed that up for sure.

I think I got it now.  Couple simple rules to follow and I'm good to go.  Thanks so much for having the patience to work through this with me.  If I said I appreciated it, it would be an understatement of historic proportions!

 

[spiritrider]

You are getting closer, but while the catch-up contribution is not included in the 415c limit, it must deducted from payroll. So you only have $18K - mandatory deductions available for employee after-tax contributions.

I just though of another important point. Employee deferrals must come from compensation not already received. So whatever W-2 wages you have already paid yourself can not be used for employee deferrals.

 

[Robert]

spiritrider,

Uh oh . . . I hadn't considered the "compensation not already received" part.  Am I confused again or does this even further limit contributions.  In other words,  I can't "defer" any more "after-tax" money than my net salary each month (catchup provision or not).   Net salary is the only compensation, not already received or is there some other definition the IRS uses?  How about if I follow ReFinDoc's advice and go back to being a sole proprietor?   I can't see how the "comp not received" could apply to a sole proprietor.  I believe, as far as the IRS is concerned,  a check is constructively received the day it arrives in the mail.

Think it's time for me to throw in the towel and get some professional help.  Thanks very much to all for trying.

[spiritrider]

This is correct, you can not make W-2 deferrals except prospectively from payroll. The maximum amount is the pay period's compensation - mandatory withholding or any maximum deferral percentage set by the plan whichever is lower. Whatever W-2 wages you have already received can not be the basis for deferrals.

Yes, there are far less restrictions on employee deferrals for a sole proprietor. You have until your tax filing deadline including extensions to make employee deferrals and employer contributions.

I see no requirement that employee after-tax contribution must come from compensation not already received. However, I don't know how that would work.

Employer contributions are based on total W-2 compensation including previously payrolls and can be made at anytime from the corporation's accounts before the S-Corps tax filing deadline including extensions.

I hope this is received in the manner in which it is intended. I don't mean any disrespect. You really do not seem currently to have the knowledge necessary to administer your own one-participant 401k from a mainstream provider, let alone a plan where you just have a plan document from Ascensus. A one participant 401k is still 99.95% a 401k subject to all the rules and regulations. The problem is you won't know what you don't know and that can cause a costly mistake. There can be serious penalties for 401k plan errors.

In my opinion you should either use a one-participant plan from a mainstream provider. Or engage the services of a Third Party Administrator (TPA ) for most administrative services at least initially. Then as you get more comfortable you can take over services one by one. I consider myself a reasonably knowledgeable individual when it comes to tax-advantaged employer retirement plans, but I am not a professional and I am not sure I would even try to roll my own custom plan.

P.S. When I say use a TPA, I really mean that. While many CPAs are good accountants, many of them only have cursory  knowledge of employer retirement plans. Enough to provide basic services to their clients: calculate the amount of contributions, apply limits and deadlines, but not much more.

[jfoxcpacfp]

Robert wrote:

How about if I follow ReFinDoc’s advice and go back to being a sole proprietor?

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Yes, you can do this, possibly even retroactively in some states (not beyond the beginning of the year) if you haven't been writing payroll checks to yourself (some small businesses do this only once/year at the EOY). You'll have to file Articles of Dissolution with your state and close down other accounts.

As spiritrider recommended and you previously acknowledged, an S-corp (even without a retirement plan) is rarely a DIY project.

[Robert]

spiritrider ,

I completely agree with your assessment of my inadequate knowledge base and already had started the TPA interview process last week.  I asked my old CPA if he wanted to get involved and he just laughed.  He agreed what I need is a good TPA and made a couple referrals.  Ultimately, I plan to talk to couple of large, well-established national firms, a local pension corp and a couple web-based operations.   I have to say that initial interactions have been discouraging . . . there is even disagreement among TPAs as to what is permissible with something as basic as catch-up contributions.   I sense this is not going to be a simple process either . . . .

When the dust settles, I'll follow up and let you know what happened.

[Robert]

Here is the final, follow-up post I promised, with what I learned.  I spoke with 5 different TPA/pension consulting corps and, after some effort, got them all to agree on a reasonable plan.   Learned a LOT from my emails and phone calls.  I thought my basic idea and related questions were pretty simple but, for the most part, they stumped the phone/sales agents.  In 4 of 5 cases, I ended up having to speak with their attorneys to get get clear answers.  When the dust settled, things are a bit simpler than we were making them.   Here is the take home:

1.  As spiritrider recommended, I'm going to use/hire TPA for first year.  After first year, record keeping and tax document filing requirements are pretty minimal.  At this point, I plan to take over and follow the template.  Leaning towards using a small, local TPA because it would facilitate the transfer and he's willing to help as a paid consultant down the line, as needed (though he doesn't think I'll need it, once up and running).  There are a number of IRS approved, plan documents available that we can use.

2.  Not a significant difference as to whether I do as an S Corp employee or a Sole P.   I'll continue to use my S Corp.  My max allowed, total (Roth and non-Roth) after-tax contribution will be my W2 income.  Interestingly, 401(k) regulations specifically state that one may not defer from compensation already received.  Given that this rule is clearly stated in the law, one would expect similar language in the 401(m) rules pertaining to voluntary, after-tax contributions. It's simply not there.  Furthermore, it's not there in ANY of the plan documents I may use.   So, it seems I'm allowed to cut a year-end check for Roth and non-Roth, after-tax contributions to my plan, up to the amount in Box 1 of my W2.  As a side note, there are some old IRS revenue rulings that allow direct employee contributions but they predate ERISA and applied to some old Thrift plans.  This greatly facilitates plan management and contributions.  I'll do the Roth contrib via payroll deduction and the balance via check.

3.  Regular contribs + Catch-up cannot exceed 100% income (as opposed to Regular alone).

4.  Among the attorneys, there remains disagreement whether a ROTH account and ROTH contributions are, in fact, necessary to make after-tax, non-Roth contributions.  On the other hand, if, by chance, I make over $54k, I can't take advantage of catch-up contribution until I make the $18k of elective contribs to a Roth.

It was an educational and interesting experience.  Per some IRS pubs and in my mind, I always thought a solo-401k was essentially the same as a regular, qualified 401k.  After this experience, I'm not so sure anymore!

Thank you, again, to everyone for you help.