Author Topic: Mega backdoor Roth questions  (Read 8946 times)

nanu

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Mega backdoor Roth questions
« on: August 04, 2015, 05:12:06 AM »
I'm sure this was asked before, but I keep finding conflicting answers, depending on where I look exactly.
My situation is pretty simple (I think) - Vanguard is my employer's 401K provider, and I can make three types of contributions: pre-tax, Roth post-tax, or just post-tax.
The pre-tax + Roth post tax can amount to no more than $18K/year (in 2015), so I elect to defer the entire amount pre-tax to minimize my tax burden.

Additionally, I can contribute to post-tax (but I don't get the employer match on those funds) if I want.
Vanguard also allows me to "Convert to Roth within your plan" (quote from their website) either the pre-tax or post-tax money I have in the 401K.
I know that if I convert the pre-tax money, I will be required to pay taxes on all of it, and that if I roll over the post-tax money I only need to pay tax on the profits (which shouldn't exist, because I can start the transfer myself from the website on the same day money gets deposited into the 401K).

What I'm not sure of - if I contribute post-tax money, and "Convert to Roth within your plan", when can I withdraw it, and what taxes will I pay when I do?

(I also contribute to HSA and IRA [traditional this year, Roth next year using the backdoor because I won't be able to deduct the contribution to a traditional next year]. Anything else I should do to minimize tax burden?)

MDM

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Re: Mega backdoor Roth questions
« Reply #1 on: August 04, 2015, 10:37:29 AM »
What I'm not sure of - if I contribute post-tax money, and "Convert to Roth within your plan", when can I withdraw it, and what taxes will I pay when I do?
In short, at any time if you don't mind a 10% tax, or after five years for tax free.  See https://www.kitces.com/blog/understanding-the-two-5-year-rules-for-roth-ira-contributions-and-conversions/ for more details.

brooklynguy

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Re: Mega backdoor Roth questions
« Reply #2 on: August 04, 2015, 11:24:06 AM »
In short, at any time if you don't mind a 10% tax, or after five years for tax free.

I don't think this is right.  There would be a five year waiting period to avoid a 10% penalty on any earnings on the post-tax contributions that were rolled into the Roth, but in the OP's fact pattern there should be none.  The amount of the post-tax contributions themselves (the principal) that is rolled into the Roth can be withdrawn at any time with no penalty (that is, once you've gotten them out of the Roth 401(k) into a Roth IRA, which is presumably what we're talking about -- there are likely to be stringent restrictions on withdrawing amounts in the Roth 401(k) sub-account while still employed).

MDM

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Re: Mega backdoor Roth questions
« Reply #3 on: August 04, 2015, 11:35:45 AM »
There would be a five year waiting period to avoid a 10% penalty on any earnings on the post-tax contributions that were rolled into the Roth
That is correct.

seattlecyclone

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Re: Mega backdoor Roth questions
« Reply #4 on: August 04, 2015, 01:27:48 PM »
Just to be clear, the OP is proposing to do an in-plan Roth conversion within the 401(k) account. This is initially taxed the same as if the money was rolled out of the plan into a Roth IRA, however early withdrawals from Roth 401(k) accounts (aka "designated Roth accounts") are treated a bit differently from Roth IRA withdrawals. This IRS page states that nonqualified withdrawals from designated Roth accounts are pro-rated between earnings and basis. This is different from the Roth IRA's ordering rules where the contributions always come out first, then conversions, then earnings.

If you later roll your Roth 401(k) funds over to a Roth IRA, this page states that the amount treated as "investment in the contract" will be considered contributions for the purpose of Roth IRA ordering rules, and earnings in the designated Roth account will be treated as earnings in the Roth IRA.

Also keep in mind that your plan may restrict you from withdrawing money from your Roth 401(k) account while you still work for the company.

brooklynguy

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Re: Mega backdoor Roth questions
« Reply #5 on: August 04, 2015, 01:41:35 PM »
FYI, this pertinent and very timely blog post from Kitces just hit my inbox:

https://www.kitces.com/blog/intra-plan-conversions-to-a-roth-401k-and-converting-in-service-distributions-from-a-401k-plan-to-a-roth-ira/

I think this may be the first time Kitces has explicitly acknowledged his belief that the Mega Backdoor Roth strategy (which he refers to in the article as "a kind of 'supercharged' backdoor Roth contribution") is kosher.  Interestingly, though, he says "as with other backdoor Roth contributions, its probably still a good idea to let the contribution 'season' in the account for a while, rather than trying to contribute and immediately convert" (presumably to avoid potential use by the IRS of the "step doctrine" to tax the two-step transaction according to its true economic reality, as discussed in his article on the regular backdoor Roth linked to in this article).  He's always been an outlier in how conservative he is on these issues, though -- I think there's pretty much a general consensus among the tax cognoscenti that the IRS has already backed itself into a corner and effectively (though not actually) "forfeited" the right to challenge the validity of backdoor Roth (and now mega backdoor Roth) transactions, which are in widespread use among taxpayers.

Cathy

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Re: Mega backdoor Roth questions
« Reply #6 on: August 04, 2015, 03:58:29 PM »
He's always been an outlier in how conservative he is on these issues, though -- I think there's pretty much a general consensus among the tax cognoscenti that the IRS has already backed itself into a corner and effectively (though not actually) "forfeited" the right to challenge the validity of backdoor Roth (and now mega backdoor Roth) transactions, which are in widespread use among taxpayers.

Have you ever actually seen a scholarly legal argument in favour of the legality of the gambit commonly referred to as the "backdoor Roth IRA"? I have never seen such an argument, and I was unable to locate one with a quick search just now either. This post I am making now might be the first post on the internet to provide a cogent legal argument in favour of the gambit.

I think the strongest argument would be there is no statutory basis for the application of the economic substance doctrine to the contribution-conversion backdoor Roth IRA transaction. Currently, "almost all district and appellate courts" suspend the plain meaning of the statute when applying this doctrine, but the issue has never been explicitly decided by the Supreme Court, and some scholars argue that the doctrine is only appropriate when authorised by statutory language (which is lacking in regards to the backdoor Roth IRA scheme). See Brief of Amicus Grewal in US v. Woods, pp 6-11.

Do you have any other argument supporting the backdoor Roth IRA? Have you seen any other arguments posted anywhere?

MoonShadow

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Re: Mega backdoor Roth questions
« Reply #7 on: August 04, 2015, 04:03:34 PM »
Please, do not make roth contributions to a 401k.  I did this for a time, and it screwed some things up.  The law doesn't permit you to treat those funds differently than your pre-tax/traditional funds, and you lose a great deal of control that you would have if you just kept the 401k traditional and the IRA roth.  As for the mega rollover, that assumes that you can contribute straight after-tax funds in excess of the $18k or so annual limit on other contributions.  No one gets matching funds on after-tax contributions, that would violate the tax code, actually.

MoonShadow

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Re: Mega backdoor Roth questions
« Reply #8 on: August 04, 2015, 04:10:43 PM »

Do you have any other argument supporting the backdoor Roth IRA? Have you seen any other arguments posted anywhere?

IIRC, the IRS issued a "clarification" about how they were to handle in-service distributions, that specificly permitted the separation of the pre-tax and post-tax (non roth) funds at that time into a traditional and roth IRA, respectively.  The ratio of those funds must be maintained, however.  i.e.; if your post-tax funds are 50% of your 401k's value; half of the rollover must go into the traditional IRA and half must go into the Roth IRA, which pretty much excludes the possibility of a partial rollover.  This is tricky business, legally speaking.  If you have doubts, don't do it.

MDM

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Re: Mega backdoor Roth questions
« Reply #9 on: August 04, 2015, 04:13:25 PM »
No one gets matching funds on after-tax contributions, that would violate the tax code, actually.

Do you mean that if a company provides matching funds for Roth 401k contributions (which some do), that those funds must go into a traditional 401k account (e.g., see http://www.irs.gov/Retirement-Plans/Retirement-Plans-FAQs-on-Designated-Roth-Accounts#10) ?

Cathy

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Re: Mega backdoor Roth questions
« Reply #10 on: August 04, 2015, 04:19:42 PM »
...the IRS issued a "clarification"...

First of all, the IRS does not have the authority to override the law, even in a manner that favours taxpayers. These positions can always be revised, and there might be circumstances where a taxpayer would want to argue that a backdoor Roth is invalid to evade the income limit on Roth contributions. See my previous post on rewards for helping the IRS collect tax.

Second, you haven't cited the alleged IRS guidance, which is typical of most or all people who comment on the backdoor Roth IRA issue -- they don't cite any legal authority for their claims, nor do they provide an actual legal argument.

Third, even if the guidance says what you say, it would be irrelevant to the issue described in my previous post in this thread.

MoonShadow

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Re: Mega backdoor Roth questions
« Reply #11 on: August 04, 2015, 04:26:11 PM »
No one gets matching funds on after-tax contributions, that would violate the tax code, actually.

Do you mean that if a company provides matching funds for Roth 401k contributions (which some do), that those funds must go into a traditional 401k account (e.g., see http://www.irs.gov/Retirement-Plans/Retirement-Plans-FAQs-on-Designated-Roth-Accounts#10) ?

No.  Any after-tax funds that the 401k accepts that are beyond the normal contribution limits for a 401k (somewhere around $18k per year, iirc) cannot be matched.  Roth funds can be matched, but I don't know if they must count only as traditional contributions.  I do know that my own company does count all matching funds as pre-tax/traditional contributions, whether the employee constributions are traditional or roth.

MoonShadow

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Re: Mega backdoor Roth questions
« Reply #12 on: August 04, 2015, 04:28:31 PM »
...the IRS issued a "clarification"...

First of all, the IRS does not have the authority to override the law, even in a manner that favours taxpayers. These positions can always be revised, and there might be circumstances where a taxpayer would want to argue that a backdoor Roth is invalid to evade the income limit on Roth contributions. See my previous post on rewards for helping the IRS collect tax.

Second, you haven't cited the alleged IRS guidance, which is typical of most or all people who comment on the backdoor Roth IRA issue -- they don't cite any legal authority for their claims, nor do they provide an actual legal argument.


Here you go.

http://www.irs.gov/pub/irs-drop/n-14-54.pdf

MDM

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Re: Mega backdoor Roth questions
« Reply #13 on: August 04, 2015, 04:38:10 PM »
No.  Any after-tax funds that the 401k accepts that are beyond the normal contribution limits for a 401k (somewhere around $18k per year, iirc) cannot be matched.
Cannot?  As in prohibited by law?  Do you have a reference for that?  As the combined "employee + employer" contribution limit is $53K, what prevents an employer from saying "I'll match your above-$18K contributions 1 for 1 until we hit the $53K total"?

Quote
Roth funds can be matched, but I don't know if they must count only as traditional contributions.  I do know that my own company does count all matching funds as pre-tax/traditional contributions, whether the employee constributions are traditional or roth.
Based on the IRS language, it would appear that "must" is correct.

Cathy

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Re: Mega backdoor Roth questions
« Reply #14 on: August 04, 2015, 04:38:51 PM »
Here you go.

http://www.irs.gov/pub/irs-drop/n-14-54.pdf

What part of that document do you believe is relevant to the issue discussed in my post that you responded to? As far as I can tell, it's all irrelevant.

Look, I'm making a point here, and it is the following: A lot of people all over the internet believe that the strategy commonly referred to as the backdoor Roth IRA is a valid way to evade the income limits on contributions to a Roth IRA, but those assertions are not supported by any scholarly legal argument. To be clear, I am not expressing any view on the merits of this issue. I am just questioning brooklynguy's suggestion that there is any kind of consensus here. In order for there to be a consensus, there would actually need to be people presenting legal argument. Until my post earlier in this thread, I've never seen such an argument anywhere on the internet.

People parroting an unanalysed assertion is not evidence of a consensus among the "tax cognoscenti"; it's just a case of the blind leading the blind, unless of course there really has been previous scholarly discussion of this issue, which is a possibility I raised in my earlier reply to brooklynguy, although it has not been borne out by any citations to such discussion.

MoonShadow

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Re: Mega backdoor Roth questions
« Reply #15 on: August 04, 2015, 04:47:32 PM »
No.  Any after-tax funds that the 401k accepts that are beyond the normal contribution limits for a 401k (somewhere around $18k per year, iirc) cannot be matched.
Cannot?  As in prohibited by law?  Do you have a reference for that?  As the combined "employee + employer" contribution limit is $53K, what prevents an employer from saying "I'll match your above-$18K contributions 1 for 1 until we hit the $53K total"?


Well, not exactly.  The employer can actually do this, but they can't take it off their own corporate taxes like they can for the normal pre-tax or roth contributions.  But no, I don't have a reference for this one at this time.

MoonShadow

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Re: Mega backdoor Roth questions
« Reply #16 on: August 04, 2015, 04:53:51 PM »
Here you go.

http://www.irs.gov/pub/irs-drop/n-14-54.pdf

What part of that document do you believe is relevant to the issue discussed in my post that you responded to? As far as I can tell, it's all irrelevant.

Look, I'm making a point here, and it is the following: A lot of people all over the internet believe that the strategy commonly referred to as the backdoor Roth IRA is a valid way to evade the income limits on contributions to a Roth IRA, but those assertions are not supported by any scholarly legal argument.


Well, before we continue, can we clarify something first?  The title of this thread is "mega backdoor" which is actually something different than the "backdoor Roth".  Granted, both terms are rather vague; but the "mega backdoor" refers to using a 401k plan with in-service distributions to contribute more into a roth in a given year than the standard contribution limit permits.  This is not a method to permit someone who makes too much income in order to contribute to a Roth IRA normally to do so, and I'm pretty sure (of the opinion) that the "backdoor Roth" is a violation of the step doctrine that will be killed by Obama's 2016 budget rules anyway.

http://www.forbes.com/sites/ashleaebeling/2015/02/02/obama-budget-would-prohibit-backdoor-roth-iras/

Cathy

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Re: Mega backdoor Roth questions
« Reply #17 on: August 04, 2015, 05:00:38 PM »
Well, before we continue, can we clarify something first?  The title of this thread is "mega backdoor" which is actually something different than the "backdoor Roth". ...

My first post in this thread was quite unambiguous. It responded to a specific claim that brooklynguy made. You then responded with something irrelevant.

MoonShadow

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Re: Mega backdoor Roth questions
« Reply #18 on: August 04, 2015, 05:12:18 PM »
Well, before we continue, can we clarify something first?  The title of this thread is "mega backdoor" which is actually something different than the "backdoor Roth". ...

My first post in this thread was quite unambiguous. It responded to a specific claim that brooklynguy made. You then responded with something irrelevant.

It looks like I'm going to have to be more blunt than I was before.

The original post was asking about the "mega backdoor" method, not the one you referred to in your post above.  Therefore, your posts are off topic to this thread, and are the irrelevant ones.  At no point was I trying to respond to your 'backdoor roth" posts, per se; and I may have been confused before by assuming that you were actually attempting to address the OP.  I apologize for any unnecessary cognitive dissonance this may have caused you in the meantime.

Cathy

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Re: Mega backdoor Roth questions
« Reply #19 on: August 04, 2015, 05:15:43 PM »
It looks like I'm going to have to be more blunt than I was before.

The original post was asking about the "mega backdoor" method, not the one you referred to in your post above.  Therefore, your posts are off topic to this thread, and are the irrelevant ones.  At no point was I trying to respond to your 'backdoor roth" posts, per se; and I may have been confused before by assuming that you were actually attempting to address the OP.  I apologize for any unnecessary cognitive dissonance this may have caused you in the meantime.

My posts are not off topic; that is an inane argument that I essentially addressed in a previous thread. There is no need to develop that argument again here, but generally speaking, the title of the post does totally determine what can be discussed in the thread. In particular, what happened here is that brooklynguy made a claim which I thought was suspect, so I responded to it. It would take quite a stretch to argue with a straight face that that is somehow "off topic".

That said, I normally do not engage in these kind of "back and forth" discussions because they add no value. My first post here contained an interesting legal argument that I wanted to share, and I think brooklynguy might get some value out of it (it was posted primarily for his benefit). There was no real reason for me to reply to your posts and I should have declined to do so.

MoonShadow

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Re: Mega backdoor Roth questions
« Reply #20 on: August 04, 2015, 05:33:06 PM »
There was no real reason for me to reply to your posts and I should have declined to do so.

Probably so.

brooklynguy

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Re: Mega backdoor Roth questions
« Reply #21 on: August 04, 2015, 08:30:42 PM »
Have you ever actually seen a scholarly legal argument in favour of the legality of the gambit commonly referred to as the "backdoor Roth IRA"?

No, but there has been plenty of discussion on the topic by knowledgable and thoughtful people like Kitces and Alan S. on Bogleheads (and those are the type of commentators who I meant by the "tax cognoscenti").  My post was not really addressing the "legality" of the backdoor Roth IRA in the sense of how it would fare if tested in court, but the practical risk that the IRS would challenge it at this stage of the game. 

On these types of issues, there can never really be 100% certainty, and the best we can do is handicap the risks involved (incidentally, the thread I started on the mega backdoor Roth a year ago after I first learned of it developed into a discussion of the possible lack of consensus and the degree of risk involved).

MDM

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Re: Mega backdoor Roth questions
« Reply #22 on: August 04, 2015, 09:46:20 PM »
As you can see, that post was a lot of work, so I don't feel like analysing the specific hypothetical (and vague) plan discussed above in the present thread.

Quite alright.  The plan mentioned was merely a "for example" in the discussion about employers legal ability to match (in whatever ratio) employee contributions above the $18K deductibility limit, and not worth a full blown Cathyesque analysis. :)

brooklynguy

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Re: Mega backdoor Roth questions
« Reply #23 on: August 05, 2015, 07:16:19 AM »
Have you ever actually seen a scholarly legal argument in favour of the legality of the gambit commonly referred to as the "backdoor Roth IRA"?

No, but there has been plenty of discussion on the topic by knowledgable and thoughtful people like Kitces and Alan S. on Bogleheads (and those are the type of commentators who I meant by the "tax cognoscenti").  My post was not really addressing the "legality" of the backdoor Roth IRA in the sense of how it would fare if tested in court, but the practical risk that the IRS would challenge it at this stage of the game. 

On these types of issues, there can never really be 100% certainty, and the best we can do is handicap the risks involved (incidentally, the thread I started on the mega backdoor Roth a year ago after I first learned of it developed into a discussion of the possible lack of consensus and the degree of risk involved).

I realized that my post could be interpreted to mean that I believe the backdoor Roth strategy is illegal but imparts a low risk of getting caught or suffering consequences, so I want to clarify that that's not what I meant to suggest.  Each step of the strategy is clearly permitted by the words of the tax code.  However, because it allows you to accomplish something indirectly that you cannot accomplish directly (and is therefore usually thought of as a "loophole"), there are legal arguments that it may be disallowed.  Because the issue has (as far as I know) never been tested in court, it remains an unsettled question of law.

As Cathy said, there does seem to be a curious lack of substantive discussion of this issue.  As always, Cathy, I appreciate your refusal to take anything for granted and your thoughtful analysis.

***Like all of my posts in the forum, this does not constitute legal or tax advice***

ZiziPB

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Re: Mega backdoor Roth questions
« Reply #24 on: August 05, 2015, 12:16:40 PM »
As to the question whether an employer can match post-tax (not Roth) contributions, apparently they can because my employer does so.  The match is simply stated as a percentage of your salary, it is not tied to the tax status of employee's contributions.  In fact the plan explicitly says that the match applies to post-tax contributions as well.  I suspect a lot (if not all) of plans that allow post-tax contributions also provide for match on these contributions because otherwise it would not work. 

To give you a specific example, my employer matches dollar for dollar the first 6% of my salary, on a paycheck-per-paycheck basis (i.e. I have to contribute at least 6 percent in each pay period).  At the same time the plan allows employees to make post-tax contributions, after they exhaust the $18K pre-tax limit.  So say, I want to take advantage of the post-tax contribution feature and I set my contributions at 20% which will amount to $25K per year.  So at some point in the year I will have hit $18K and my contributions are now post-tax.  If the employer did not continue matching after I hit the $18K limit, I would not get the full 6%, which would violate the provision of the plan that provides that employer will provide a match of 6%. 

MoonShadow

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Re: Mega backdoor Roth questions
« Reply #25 on: August 05, 2015, 12:20:08 PM »
As to the question whether an employer can match post-tax (not Roth) contributions, apparently they can because my employer does so.  The match is simply stated as a percentage of your salary, it is not tied to the tax status of employee's contributions.  In fact the plan explicitly says that the match applies to post-tax contributions as well.  I suspect a lot (if not all) of plans that allow post-tax contributions also provide for match on these contributions because otherwise it would not work

Mine allows post-tax (non-roth) contributions, and specificly denies the matching funds to after-tax contributions.  It does permit them for Roth contributions, however.

ZiziPB

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Re: Mega backdoor Roth questions
« Reply #26 on: August 05, 2015, 01:26:34 PM »
As to the question whether an employer can match post-tax (not Roth) contributions, apparently they can because my employer does so.  The match is simply stated as a percentage of your salary, it is not tied to the tax status of employee's contributions.  In fact the plan explicitly says that the match applies to post-tax contributions as well.  I suspect a lot (if not all) of plans that allow post-tax contributions also provide for match on these contributions because otherwise it would not work

Mine allows post-tax (non-roth) contributions, and specificly denies the matching funds to after-tax contributions.  It does permit them for Roth contributions, however.

Interesting.  So you basically have a choice of doing post-tax contributions or getting the full match?  Or do they match on different basis per paycheck or have some kind of catch up mechanism?

MoonShadow

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Re: Mega backdoor Roth questions
« Reply #27 on: August 05, 2015, 01:30:27 PM »
As to the question whether an employer can match post-tax (not Roth) contributions, apparently they can because my employer does so.  The match is simply stated as a percentage of your salary, it is not tied to the tax status of employee's contributions.  In fact the plan explicitly says that the match applies to post-tax contributions as well.  I suspect a lot (if not all) of plans that allow post-tax contributions also provide for match on these contributions because otherwise it would not work

Mine allows post-tax (non-roth) contributions, and specificly denies the matching funds to after-tax contributions.  It does permit them for Roth contributions, however.

Interesting.  So you basically have a choice of doing post-tax contributions or getting the full match?  Or do they match on different basis per paycheck or have some kind of catch up mechanism?

No.  They match 50% of the first 7% of "qualified" contributions; so up to 3.5% of income for contributions either traditional pre-tax or Roth.  The post-tax contributions are simply treated separately.

ZiziPB

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Re: Mega backdoor Roth questions
« Reply #28 on: August 05, 2015, 02:18:41 PM »
As to the question whether an employer can match post-tax (not Roth) contributions, apparently they can because my employer does so.  The match is simply stated as a percentage of your salary, it is not tied to the tax status of employee's contributions.  In fact the plan explicitly says that the match applies to post-tax contributions as well.  I suspect a lot (if not all) of plans that allow post-tax contributions also provide for match on these contributions because otherwise it would not work


Mine allows post-tax (non-roth) contributions, and specificly denies the matching funds to after-tax contributions.  It does permit them for Roth contributions, however.

Interesting.  So you basically have a choice of doing post-tax contributions or getting the full match?  Or do they match on different basis per paycheck or have some kind of catch up mechanism?

No.  They match 50% of the first 7% of "qualified" contributions; so up to 3.5% of income for contributions either traditional pre-tax or Roth.  The post-tax contributions are simply treated separately.

Got it.  I guess there are different ways to skin the cat ;-)  In any event, to whoever asked the question, post-tax contributions can be matched.

brooklynguy

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Re: Mega backdoor Roth questions
« Reply #29 on: August 12, 2015, 01:34:57 PM »
FYI, Kitces just put out a new article relevant to discussion above on the "step transaction doctrine" as it pertains to the backdoor Roth strategy (and, by extension, the mega backdoor Roth strategy):

https://www.kitces.com/blog/how-to-do-a-backdoor-roth-ira-contribution-while-avoiding-the-ira-aggregation-rule-and-the-step-transaction-doctrine/

Cathy

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Re: Mega backdoor Roth questions
« Reply #30 on: August 13, 2015, 12:12:57 AM »
I think Kitces' latest article isn't as rigorous as his usual content. The "step transaction doctrine" is basically a tool of statutory interpretation that a court can use as an interpretive aid to determine whether a given transaction falls within a particular statute. An application of the doctrine necessarily involves a close reading of the actual statutory language, which is notably absent from the Kitces article.

The case Kitces cites, Gregory v. Helvering, 293 US 465, is illustrative of the above. In that case, the Supreme Court dealt with an alleged corporate "reoganisation" which achieved certain tax benefits. The Court was not impressed with the purported reorganisation and found that "[t]he whole undertaking ... was in fact an elaborate and devious form of conveyance masquerading as a corporate reorganization, and nothing else". In other words, the Court's decision was that the transaction was not a reorganisation within the meaning of the statute. The logic here is that, according to the Court, when Congress used the impugned terms in the statute, it intended to refer to only a sincere business transaction and not a sham transaction. The key thing to understand is that the Court's decision was rooted in an interpretation of the statutory language. In fact, the Court explicitly affirmed that "[i]t is quite true that if a reorganization in reality was effected within the meaning of [the statute], the ulterior purpose mentioned will be disregarded". The problem for the taxpayer in that case was that his transaction fell outside of the statutory language upon which he had hoped to rely.

By contrast, Kitces does not base his argument on any statutory text. What Kitces is really applying is the "economic substance doctrine", which allegedly allows courts to analyse transactions on the basis of their true economic nature without looking at the statutory language. The existence of the extra-statutory doctrine has been disputed. See Grewal (2007).

26 USC 7701(o)(5)(B) could also be relevant. This statute does not explain the economic substance doctrine, but it does say that this doctrine only applies to "transactions entered into in connection with a trade or business or an activity engaged in for the production of income". The transaction commonly referred to as the backdoor Roth IRA could conceivably fall within that test, since IRA contributions are related to "compensation", which comes from a "trade or business", but there are also arguments that it does not fall within that test.

If we want to apply specifically the "step transaction doctrine", we need an actual argument based in statutory language. Let's try to come up with one. The first attempt might be to argue that, as a matter of statutory interpretation, the backdoor contribution is part of the "aggregate amount of contributions for any taxable year to all Roth IRA" within the meaning of 26 USC 408A(c)(2). This would cause it to be subject to normal income limits. The problem here is that 26 USC 408A(c)(6)(B) explicitly says that "[a] qualified rollover contribution shall not be taken into account for purposes of paragraph (2)" (the provision previously cited). That statutory language cannot just be ignored when applying the step transaction doctrine (as opposed to the alleged extra-statutory economic substance doctrine). The next attempt might be to argue that the alleged rollover involved in the backdoor Roth IRA conversion is not a "qualified rollover contribution", but that term also has a statutory definition and it is clearly satisfied.

I cannot see any obvious argument based in the statutory language that would allow the "step transaction doctrine" to apply. That only leaves extra-statutory arguments. Professor Grewal says that these arguments have no basis in law, but even if we assume they do, there is at least a plausible argument that the backdoor contribution is a personal non-business transaction, exempted from the application of the economic substance doctrine by 26 USC 7701(o)(5)(B).

I express no opinion on any of these issues, but the Kitces article would have been better if he had carefully addressed these matters.
« Last Edit: August 13, 2015, 12:36:04 AM by Cathy »

brooklynguy

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Re: Mega backdoor Roth questions
« Reply #31 on: August 13, 2015, 07:21:33 AM »
I think Kitces' latest article isn't as rigorous as his usual content.

I agree.  It's also a bit disturbing that, as Kitces describes it, the issue is that conducting a two-step backdoor Roth contribution with the intention of circumventing the explicit restriction on making a one-step "front door" Roth contribution to achieve the same economic outcome is potentially unlawful and his proposed solution is essentially to disguise your intent.