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Proposed Legislation Would Eliminate Backdoor Roth IRAs and Mega Backdoor Roth Accounts

By Cynthia Turoski, on October 15th, 2021

Those who have been making backdoor Roth IRA contributions or mega backdoor Roths with their 401(k) plan (or are considering it), need to take action for 2021 by year end.

About Roth IRAs

A Roth IRA differs from a traditional IRA in that there is no tax benefit on the contribution, but withdrawals can be tax-free. The benefit is on the back end where all that growth can escape taxation.

This tax-free character continues on to the beneficiaries. That is especially valuable under the SECURE Act where the beneficiary must fully distribute the account within 10 years from inheriting it. The tax-free nature of these accelerated withdrawals won’t wreak havoc on their tax situation.

Roth IRAs have no required minimum distributions. If the money isn’t needed during lifetime, the account can be left intact to maximize the tax-free compounding.

Those with higher incomes are precluded from contributing directly to a Roth IRA. Years ago the income limit was removed for converting a traditional IRA to a Roth IRA, so that leaves open the opportunity to do these backdoor Roth IRAs.

What is a Backdoor Roth IRA?

If your income is too high to contribute directly to a Roth IRA, there is currently another strategy to get the money into a Roth IRA. A backdoor Roth IRA.

If you have no other pre-tax IRA balances or a SEP IRA or SIMPLE IRA, you could make a nondeductible 2021 contribution to a traditional IRA. Immediately thereafter, you could convert that balance to a Roth IRA. There are no AGI limits for a conversion. There would be no taxable effect if you hold the traditional IRA contribution in a money market fund so it doesn’t appreciate before conversion. Then you can invest it however you wish once it has been converted to a Roth IRA. If you have pre-tax IRA balances but participate in an employer retirement plan, there’s a way to “clear the deck” to allow for this backdoor Roth IRA strategy to work.

The clincher is that this strategy is on the chopping block for next year under the current tax proposals. If passed, the tax law as proposed would disallow any conversions of after-tax money which is what a nondeductible IRA contribution is. Normally, you can wait until April 15, 2022 to make your 2021 IRA contribution and convert soon after. Since this option may be eliminated for next year, you would need to make your 2021 IRA contribution and convert is all by year-end to lock in that ability this year.

Mega Backdoor Roth Accounts

For those few individuals who participate in an employer retirement plan that allows after-tax contributions and offers a Roth account inside the plan, take note. The tax proposal impacts the options you might have on that after-tax money inside the plan.

Your plan might provide that you can do an in-plan conversion of the after-tax balance into the plan’s Roth account where that portion can grow tax-free. The tax proposals on eliminating conversions of after-tax money would eliminate that option. Should you wish to take advantage of this strategy, you would need to do so this year in case the law passes.

The IRS hasn’t been a fan of these backdoor Roth strategies so the consensus thinking is that this proposed provision could very well make it into final law. Bottom line: don’t wait. Attend to this well before year-end as the process can take some time. Please consult your tax advisor as soon as possible on your specific situation. Reach out to our experts today to further discuss.

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Jess LeDonne
Director, Policy and Legislative Affairs
Jessica LeDonne Image
Jess LeDonne
Director, Policy and Legislative Affairs