Oxy 401(k) Savings Plan: Mega Backdoor Roth Strategies

How Mega Backdoor Roth Conversions Can Optimize Your Oxy Savings Plan Tax Treatment

One of the most effective ways to prepare for retirement is to maximize the usage of tax-advantaged retirement savings vehicles like an IRA or 401(k). However, “Maxing Out” your plan means something different for employees of certain companies. The RGWM team wants to highlight a unique tax planning opportunity for Oxy’s “Super Savers.” In general, many individuals we meet are frustrated by the low annual contribution limits for tax-advantaged vehicles like their Traditional or Roth IRA or their 401(k).

At $7,000/year in an IRA and $23,000/year in a 401(k), most high-income savers wish there was a place to put their excess income above these limits but don’t know where.

Enter the Mega-Roth: a unique tax strategy with no upper limit on income for eligibility.

In what appears to be a significant change, the SECURE Act 2.0 enacted in December 2022 did not have language eliminating the Mega Roth strategy in the drafting phase or final legislation. We believe this bodes well for the ongoing availability of the strategy, which we will explore in depth below.

*Base Comp. over $155,000 may contribute 1-15%, Base Comp. under $155,000 may contribute 1-30%
**2-to-1 on the first 2% of employee contributions, then 1-to-1 for the next 3%, for a total of 7%
***pending changes from Secure Act 2.0

Mega Backdoor Roth Strategy

Most Oxy employees know they can contribute to their Savings Plan through pre-tax and Roth contributions. Employees can generally contribute up to $23,000 a year ($30,500 if age 50 or older) from their paycheck. People are less aware that the Savings Plan allows for additional after-tax contributions beyond this limit. Sometimes, these after-tax funds can be converted tax-free to Roth at your convenience. The Oxy Savings Plan, fortunately, is one of the retirement plans that allow for this capability.

HERE’S HOW IT WORKS:

• Max out your Pre-Tax or Roth contributions to the Savings Plan ($23,000 for 2024)
• Receive a 7% matching contribution
• Contribute After-Tax funds up to the IRS limit ($69,000 in 2024)
• Convert After-Tax Funds to Roth Account

Consider this example:

An Oxy employee (let’s call him Bob) has a salary of $300,000. He contributes the pre-tax max of $23,000 to his Savings Plan for 2024 and receives a 7% match of $21,000 for a total of $44,000. This remains $25,000 below the IRS limit of $69,000. However, Bob can only contribute $22,000 due to the Oxy contribution limit of 15% for those making over $155,000. Let’s assume Bob then contributes $20,000 each year to the After-Tax account in the Savings Plan for five years – a total of $100,000. This money has grown over the five years to $150,000. Therefore, for conversion purposes, $100,000 is Bob’s contribution basis, and $50,000 is growth.

Tax Implications of Mega Roth Conversions

Uncle Sam isn’t far away whenever a citizen receives a tax advantage. He wants to get his share of this windfall! The IRS has instituted a Pro-Rata rule that mirrors the one associated with a traditional backdoor Roth IRA.

If Bob were to withdraw the $150k After-Tax amount from the Savings Plan, he would pay ordinary income tax on the portion of the withdrawal that represents the growth ($50k).

The same goes for a conversion from the After-Tax account to the Roth account. One-third ($50k/$150k) of any conversion will be taxable because that is the proportion of the value that is represented as growth. Conversely, this strategy would be more attractive if Bob had completed annual conversions. If Bob were to make ongoing conversions before any growth occurred, these After-Tax assets would be placed into the Roth Account and compound tax-free permanently. As the chart above shows, qualified Roth withdrawals are always tax free.

In essence, Bob can use this strategy to permanently eliminate the tax on the growth of After-Tax assets!

The Catch

If there is one, the catch is that many people already have a current After-Tax balance in their Savings Plan. If you inadvertently contribute too much to the Pre-Tax or Roth accounts, the excess automatically rolls over to the After-Tax balance. While this does not prohibit you from taking advantage of this strategy, the After-Tax balance can grow over time and complicate conversion strategies. Before making conversion decisions, it’s crucial to look at your Savings Plan statement to identify your After-Tax account balance and compare that to your contribution basis. This will give you an idea of how the Pro-Rata rule comes into play for the taxation of conversions.