What Is a Mega Backdoor Roth 401(k) Conversion?
A mega backdoor Roth 401(k) conversion is a tax-shelter strategy available to employees whose employer-sponsored 401(k) retirement plans allow them to make substantial after-tax contributions in addition to their pretax deferrals and to transfer their contributions to an employer-designated Roth 401(k).
The Build Back Better Act, H.R. 5376, passed by the House of Representatives on Nov. 19, 2021, contains provisions that, if enacted, would limit the ability of high-income taxpayers to accumulate extremely high-value balances in Roth 401(k)s and would eliminate backdoor Roth conversions for high-income taxpayers after Dec. 31, 2031.
As of spring 2022, the Build Back Better Act remains stalled in the Senate, and these provisions may not come to pass, at least not in their current form. But mega backdoor Roth conversions remain an important issue—and a notable route to wealth for higher-income taxpayers.
- H.R. 5376, the Build Back Better Act, passed by the House of Representatives in November 2021, would weaken and ultimately eliminate a lucrative tax-shelter strategy available only through certain corporate retirement plans.
- By making contributions to 401(k) plans and then transferring their account balances at little tax cost to Roth 401(k)s, some participants have accumulated permanently tax-free investment accounts.
- This backdoor Roth 401(k) conversion strategy—and a similar tax shelter using regular Roth IRAs—have enabled taxpayers with the economic means to escape significant taxes.
- Two goals motivate the Build Back Better Act's provisions attacking the Roth strategies: improving tax equity among taxpayers and collecting the revenues lost to tax-benefited strategies high-income individuals use.
Understanding Mega Backdoor Roth 401(k) Conversions
Employees electing to roll over their 401(k) accounts into designated Roth 401(k)s must pay income tax on the transfer of their pretax contributions and untaxed account earnings. Individuals who convert regular 401(k)s to designated Roth 401(k)s when still relatively young can realize tax savings on their accounts over the years that significantly outweigh the one-time income tax on the transfer of their pretax contribution amount.
In 2022, if a plan provides this option, a participant can contribute up to $20,500 ($27,000, if age 50 or older) in pretax compensation and as much as $40,500 as an after-tax contribution to a 401(k) plan for a total of $61,000 ($67,500, including the $6,500 catch-up contribution if age 50 or older).
Then, the participant can execute a transfer—a conversion—of those monies to a Roth 401(k). When untaxed regular 401(k) assets are transferred to the Roth 401(k) account and subjected to the tax on their transfer, the subsequent earnings in the account accumulate tax-free. Distributions from Roth 401(k)s are tax-free and generally must begin when the owner reaches age 72.
Why Do Critics Want to End Conversions?
High-income taxpayers have used mega backdoor conversions to Roth 401(k)s—and to Roth IRAs—to amass enormous, permanently tax-sheltered investments in these Roth vehicles. Although many 401(k) plans do not offer this conversion opportunity, the number of large corporations with highly compensated employees offering them—including AT&T, Inc., Aon PLC, and Facebook, Inc. (now Meta)—has increased in recent years.
The spread of these conversions has attracted criticism from financial writers and policymakers who view the backdoor conversion into Roth accounts as an unfair advantage for senior corporate executives. The benefits of Roth 401(k)s favor higher-income taxpayers over those with lower incomes. The contributions allowed to regular 401(k) accounts are far higher than the ceiling amounts for Roth IRAs.
The maximum Roth IRA contribution for 2022 is $6,000, plus $1,000 for employees ages 50 and above—far less than the $61,000 ($67,500 if age 50 or older) that a corporate employee can contribute in pre- and after-tax funds to a 401(k) and transfer to a designated Roth account.
In addition, annual income limits restrict eligibility for Roth IRAs. These are $214,000 for married couples filing jointly and $144,000 for single individuals in 2022; no income limits apply for participation in a 401(k), though plans will have rules about when employees qualify to participate. The transfer of regular 401(k) balances to designated Roth 401(k)s in backdoor conversions vastly increases the already significant tax benefit differential.
Tax Changes Proposed by the Build Back Better Act
If enacted in its present form, the Build Back Better Act, H.R. 5376, (BBB) as passed by the House of Representatives and awaiting consideration in the Senate, would substantially limit the use of designated Roth 401(k) accounts and Roth IRAs by high-income taxpayers to avoid income taxes.
Beginning in 2022, the House-passed BBB legislation would limit the use of Roth conversions for all taxpayers, regardless of income level, by prohibiting the rollover of after-tax 401(k) contributions (i.e., nontaxable amounts) to a designated Roth 401(k) account (or to a Roth IRA). Only rollovers of after-tax contributions and untaxed earnings that would be taxed on the transfer would be permitted.
After Dec. 31, 2031, the bill would eliminate conversions of 401(k) accounts to designated Roth 401(k) accounts (or to Roth IRAs) entirely for high-income taxpayers. High-income taxpayers are defined as individuals having modified adjusted gross incomes (i.e., AGIs without regard to certain exclusions and deductions) above specified levels. These levels would be $400,000 for single taxpayers and married persons filing separately, $450,000 for married individuals filing joint returns, and $425,000 for heads of household, each amount adjusted for inflation after 2029.
In addition, the BBB bill would increase the annual required minimum distribution (RMD) for high-income taxpayers with large retirement account balances for tax years beginning after Dec. 31, 2028, regardless of the account owner's age. Generally, increased RMD rules would apply if the aggregate value of a high-income taxpayer’s qualified retirement plans—including traditional IRAs, Roth IRAs, annuity contracts, 457(b) deferred compensation plans, and defined contribution accounts—exceeds specified amounts.
A taxpayer generally would be required to distribute 50% of the amount by which the total value of all the taxpayer’s qualified retirement plans exceeds $10 million at the end of the prior tax year. If the aggregate balance of a taxpayer’s qualified retirement accounts exceeds $20 million, the increase in the RMD would be the excess balance up to the lesser of (a) the amount required to reduce the total balance to $20 million or (2) the aggregate balance of the taxpayer’s Roth IRAs and designated Roth accounts. Income tax withholding on such increased RMD amounts, other than nontaxable Roth amounts, would apply at the rate of 35% instead of the present law rate of 10% for non-periodic distributions.
The BBB bill also would impose on plan administrators new tax-reporting obligations with respect to distributions from accounts with high balances. Administrators would have to file annual reports about defined contribution plan account balances in excess of $2.5 million with the IRS and the plan participant. In addition, information about a plan's high-balance accounts would be required in the plan’s annual registration statement filed with the Department of Labor.
What Is a Backdoor Roth 401(k) Conversion?
A backdoor Roth 401(k) conversion is the transfer of both the pretax and after-tax contributions in a regular 401(k) account to an employer-designated Roth 401(k) account. Any untaxed assets transferred to the designated Roth account will be taxed upon the transfer, but no tax will apply to all subsequent earnings, and distributions will be tax-free.
Why Are These Backdoor Conversions Criticized?
Highly compensated executives in some large corporations have used backdoor conversions—through their use of designated Roth 401(k) accounts—to create long-term tax shelters for investments. This tax-shelter strategy is available only to corporate employees whose plans permit such conversions.
Electing participants may make 401(k) contributions that are much larger than those legally permitted by other types of retirement plans. And generally, only higher-income employees can afford to participate. The tax-free treatment of these sizable account holdings is viewed as unfairly benefiting the rich.
How Likely Is Congress to Eliminate Backdoor Roth 401(k) Conversions?
The House has included provisions in H.R. 5376, the Build Back Better bill, passed on Nov. 19, 2021, that would eventually eliminate their use—and important legislators in both houses have supported them. However, the Senate has not passed the BBB bill, so it is not clear if any provisions that limit, if not end, these transactions will be enacted in 2022.
The Bottom Line
The enactment of the BBB bill and, if enacted, its inclusion of the provisions attacking backdoor Roth 401(k) conversions—or similar provisions affecting backdoor Roth IRA conversions—are uncertain. However, publicity about the abuse of Roth accounts has attracted support for the changes. And the potential $10 trillion in increased taxes to be gained from the provisions dealing with retirement plans makes them attractive revenue-raising components of the BBB, which the Biden administration intended to pay for itself.
Important members of the House and Senate tax-writing committees have supported legislative proposals to limit or eliminate mega backdoor Roth and 401(k) conversions. But given that the BBB bill has stalled in the Senate, it is questionable whether any provisions that limit or end these transactions will be enacted for some time through the BBB or other legislation.