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How do the Pro Rata rules apply to Mega Backdoor Roth Solo 401k contributions?
Many retirement savers utilize backdoor Roth IRA contributions and Mega Backdoor Roth Solo 401k conversions to get more tax-advantaged growth. However, these strategies can trigger complex pro rata tax rules. In this post, we’ll break down how the pro rata rules apply differently to Backdoor Roth IRAs versus Mega Backdoor Roth Solo 401k plans.
Backdoor Roth IRAs and the Pro Rata Rule
With a Backdoor Roth IRA, you make a non-deductible contribution to a Traditional IRA and then convert that money to a Roth IRA. This conversion would normally be taxable. However, since your contribution was non-deductible, this conversion is tax-free. The benefit is that future growth in the Roth IRA is entirely tax-free.
Here’s the catch – the pro-rata rule. If you have any existing pre-tax IRA assets (even if in other IRA accounts), the IRS won’t let you simply convert only the after-tax dollars. Instead, they make you calculate what percentage of your total IRA balances is after-tax money. That percentage of your conversion will be tax-free, while the remainder will be taxed as ordinary income.
For example, if you have $24,000 in pre-tax IRAs and want to convert a $6,000 backdoor Roth (non-deductible) contribution, only 20% of that conversion would be tax-free. You’d still owe income taxes on $4,800 of the conversion amount. As you can see, pre-existing IRA assets complicate the backdoor Roth strategy.
Mega Backdoor Roth and Solo 401k Plans
With a Solo 401k plan such as our plan that allows for Mega Backdoor Roth Solo 401k contributions, the solo 401k owner/participant makes voluntary after-tax contributions to the Solo 401k plan. As long as the funds are separately accounted for in the Solo 401k plan, the Solo 401k owner/participant can elect to convert just the after-tax dollars to either a Roth Solo 401k or Roth IRA account.
The key difference versus the Backdoor Roth IRA is that the pro rata aggregation rules are applied separately to each 401k account. So if your Solo 401k plan has the proper separate accounting in place, all of the after-tax dollars can be transferred to either the Roth Solo 401k sub-account or a Roth IRA. Any amounts in other accounts (e.g. Pre-tax or Roth) are ignored when processing the conversion.
Example Scenario:
Jennifer, a 45-year old business owner earns a healthy income that prevents her from directly contributing to a Roth IRA.
She also has a Rollover IRA worth $24,000 which contains only pre-tax sources.
Jennifer works with her financial advisor to open a solo 401k plan and makes 2023 Solo 401k contributions as a pre-tax $22,500 employee salary deferral to a pre-tax Solo 401k sub-account plus a $6,000 after-tax non-Roth contribution to a separate voluntary after-tax solo 401k sub-account, bringing her total solo 401k account balance to $28,500.
Backdoor Roth IRA Conversion:
Jennifer decided first to do a $6,000 backdoor Roth IRA contribution for 2023. Because she has the $24,000 Rollover IRA balance, the pro rata rule applies across all her IRAs. Her backdoor Roth conversion will be 80% taxable ($6,000 non-deductible IRA balances / $30,000 total IRA balances), resulting in $4,800 being added to her tax bill this year.
Mega Backdoor Roth Solo 401k Conversion:
Jennifer also decided to convert her $6,000 after-tax contributions from her solo 401k to a Roth Solo 401k sub-account. Because solo 401k plans apply the pro rata rules on an account-by-account basis, she can convert the entire $6,000 free of tax, since pre-tax balances in her other 401ks are ignored.
