Step-by-step tutorial of the Mega Backdoor Roth through Fidelity Investments

I am always looking for ways to put more money into my retirement. Chris and I currently have 10 (yes ten!) retirement accounts with a mixture of pre-tax and post-tax accounts. Each account has its own unique set of rules, contribution amounts, and investment strategies. For example, Chris, at his neurosurgical practice, has a 401k Profit Sharing Plan with Cash Balance Plan (Defined Benefit Plan) and I have a Solo 401k with Profit Sharing (we both have our Roth IRAs). A few years ago, I came across the Mega Backdoor Roth, and, as a tax advisor, I was intrigued by the fact that I could put more into my post-tax account when I am not able to maximize my pre-tax account. 

Let’s first discuss some basics:

A Roth account is an individual retirement account that enables taxpayers to contribute post-tax dollars, have it grow tax-free, and make tax-free withdrawals of their money after they retire. Great news for physicians who want tax-free income during retirement to balance out their taxable retirement accounts. 

There’s a catch though. If you earn too much, you may not be eligible to contribute the maximum $6,000 a year (2022) directly to a Roth IRA account. However, if your income is too high you can perform a backdoor Roth conversion to still contribute $6,000 a year. Learn more about a normal backdoor Roth here. But don’t confuse the individual Roth IRA with a Mega Backdoor Roth, which is used for physicians with their own business or non-W-2 side income.

With a Solo 401k profit sharing you are limited to a pre-tax contribution of $61,000 or 25% of your profit or wages, depending on your entity type, whichever is less. So, for example, if you have a single-member LLC and your profit is $250,000, you can contribute the full $61,000 into your pre-tax retirement account. But, let’s say your profit is only $40,000, you can contribute approximately $20,500 (employee deferral) and $10,000 (employer contribution) for a total of $30,500. But what about the additional $30,500 to max out to the $61,000?

That’s where something called the Mega Backdoor Roth comes in. 

The Mega Backdoor Roth is a strategy that enables physicians to contribute up to an additional $30,500 (2022) by contributing after-tax dollars to your after-tax IRA and converting that money into a Roth Solo 401k.

We’re going to run through how that works using Fidelity Investments as an example and what you need to do to report it.

How it works

Medical professionals are only eligible for a Mega Backdoor Roth under specific conditions. So, first – make sure your Solo 401k is set up with these two features:

In-service distributions –  Your plan must allow in-service distributions. This means while you’re actually an employee and part of the medical practice, you’ll be allowed to make withdrawals from your account. 

After-tax contributions – Traditionally, with a Solo 401k, you’re just making pre-tax contributions. These contributions are tax-free going in, but you pay tax on anything you withdraw at retirement time. Your plan must allow after-tax contributions to your account. 

You’ll need to have three separate accounts set up with your preferred institution. We’re using Fidelity as our example here, so this is the mechanics of how Fidelity works. 

Let’s assume you have profits of $100,000 and you are going to contribute $20,000 to your pre-tax Solo 401k profit-sharing account – that’s the amount you’re going to be taking as a tax deduction on your individual income tax return (usually as an adjustment to your adjusted gross income (AGI). 

Since your profit is over the $61,000 maximum, the $41,000 dollars ($61K-$20K pre-tax) leftover can be contributed post-tax to your account. 

This is where it gets a little confusing. In Fidelity, you have to set up 3 different accounts. Your pre-tax Solo 401k, Roth Solo 401k, and an After-Tax IRA (all three as nonprototype accounts). What you end up doing is contributing the $41,000 to the After-Tax IRA, then rolling it over tax-free to your Roth Solo 401k. 

By segregating your pre-tax dollars and post-tax dollars it helps with the pro-rate rules and makes sure you’re not commingling your pre-tax and post-tax dollars.
This is all assuming you have more than $61,000 worth of profit in your medical practice. If your profit is only $30,000 then you’ll only be able to contribute post-tax dollars of the difference of $10,000 ($30K-$20K pre-tax). You can only go up to what your profit is, or $61,000 – whichever is less. 

So to recap:

– $20,000 goes to your pre-tax account as a deduction.

– $41,000 goes into the after-tax IRA account as a post-tax contribution with no deduction. 

– You roll over the $41,000 post-tax contribution tax-free to your Roth Solo 401k.

How to set up your accounts with Fidelity Investments

You need to set up three accounts:

– Solo 401k non-prototype account – that’s your pre-tax account

– After-tax IRA non-prototype account – temporary post-tax holding account

– Roth Solo 401k account – your post-tax account

Here’s an example of what the accounts look like.

Reporting: You’ll need to create and file a Form 1099-R

As the Solo 401k owner, you’ll need to file a Form 1099-R with the IRS to report the rollover from the After-Tax IRA to the Roth Solo 401k and report the Form 1099-R on your tax return.. Whatever year you do the rollover is the year you create the Form 1099-R return. 

I HIGHLY recommend rolling over the funds immediately to avoid any gains/income accumulating. If you want to make the conversion effective for the tax year 2022, you will need to convert (move the funds or assets) by December 31, 2022. Since you are converting after-tax solo 401k funds, you will not owe income taxes on the amount converted when you file your personal Form 1040 tax return on April 15, 2023, if the amount being converted does not have any interest.

I will admit at first this concept was a bit difficult to wrap my head around. Especially making sure that you avoided the pro-rata rules as mentioned earlier. It wasn’t until I decided to implement it in my own retirement planning and figure out the mechanics that it all started to make sense! Hopefully, this article provides you with some insight into the mechanics so you can feel more comfortable with the process and make it part of your retirement strategy as well.

Please do ask for our help with anything you don’t understand

Conversions like this can be complicated, and you want to make sure you’re doing everything right. It could be a great opportunity for you to make the most of your savings, so as always, do reach out for help if you feel out of depth with this one. We’re here to support you.

Have you participated in a Mega Backdoor Roth in the past? Do you use a different institution than Fidelity? Let me know more about your experiences!