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Investing Specialists

Is the Door Closing on Backdoor Roth IRAs?

The 'mega-backdoor Roth IRA' is on the chopping block, too, but neither is a done deal.

On Sept. 13, Democrats on the House Ways and Means Committee, led by Chairman Richard Neal, released a wide-ranging tax proposal that, if enacted into law, would affect corporate taxes as well as income and capital gains taxes, the estate tax, and the tax treatment of retirement account assets.

Of course, the proposal is just that--a proposal--and it will need to pass through a deeply divided Congress before it becomes law. Given that, it may be tempting to ignore the whole thing until there’s something final. But aspects of the proposal, if they become law, are quite time-sensitive. A higher capital gains rate would be retroactive to Sept. 14, 2021, but most of the proposed changes would go into effect in 2022. That leaves open a small window for individuals to enact changes in their financial plans between now and year-end.

While many aspects of the proposal will have a significant effect on people with a lot of income, wealth, or both, the changes to the backdoor Roth IRA and to a lesser extent the mega-backdoor Roth IRA merit attention because they’re currently in use among more-mainstream investors (that is, you don’t have to be super-rich to be taking advantage of them).

What’s Under Consideration
A unifying theme of the tax changes put forth by the Democrats is that they increase taxes on higher-income taxpayers to pay for other Democratic priorities, and they do so in two key ways. The first is through outright tax increases. The proposal would re-establish 39.6% as the top ordinary income tax rate starting next year, and it also introduces a new top capital gains tax rate of 25%--up from 37% and 20%, respectively. As noted above, the capital gains rate would apply to gains incurred after Sept. 14, 2021. Both the higher income and capital gains rates would apply to single taxpayers with more than $400,000 in income and married couples filing jointly with more than $450,000 in income. As has been noted elsewhere, that amounts to a significant marriage penalty, in that a couple would only need to have $50,000 more in income than a single person to be subject to the highest rate. The proposal also calls for a 3% surtax on individual and married taxpayers whose modified adjusted gross incomes exceed $5 million. A 3.8% surtax already applies to certain taxpayers who have high investment income; this surtax would be on top of that.

In addition to those tax increases, the proposal takes steps to curtail tax-sheltering techniques for wealthy individuals. Although President Biden had campaigned on limiting the amount of assets that could be passed to heirs with a step-up in cost basis (meaning the cost of an asset at the date of death becomes the inheritor’s cost basis), the proposal is silent on this issue. Instead, the proposal calls for reducing the exemption amount for estate and gift tax to $5 million (inflation-adjusted), down from $11.7 million per person today. The lower estate/gift tax exemption amount was scheduled to go into effect in 2026; this proposal accelerates it to next year. The proposal also imposes limitations on the extent to which individuals with very sizable tax-sheltered account balances can make additional contributions and enjoy tax-deferred compounding through those accounts.

Of greater import for smaller investors, however, is that the proposal would dramatically curtail use of the backdoor Roth IRA and mega-backdoor Roth IRA maneuvers. The former, especially, has become a mainstay financial-planning strategy for upper-middle-income and upper-income investors.

Don’t Let the (Back)Door Hit You on the Way Out
If executed properly, the backdoor Roth IRA and mega-backdoor Roth strategies entail very little in tax outlays but have the potential to result in significant tax savings for investors who hold them for the long haul. That’s likely what put them in the sights of Congress: They bring in little revenue for the government and reduce future tax receipts, too.

The more popular of the two maneuvers, the backdoor Roth IRA, lets high-income taxpayers fund Roth IRA accounts, even though they’re shut out of making direct Roth IRA contributions because they earn too much. (For 2021, the income threshold for direct Roth contributions is $140,000 for single filers and $208,000 for married couples filing jointly.) To get into a Roth through the backdoor, the investor funds a traditional IRA using aftertax dollars. (Anyone can contribute to a traditional IRA as long as they have earned income.) Those contributions are by definition aftertax because, if someone earns too much to make a direct Roth IRA contribution, they also earn too much to deduct their IRA contribution on their tax return. Once the traditional IRA is up and running, they can then convert those contributions to Roth. If investors do so shortly after making the contribution, they’ll be able to pay little or no taxes on the conversion because the contribution dollars have already been taxed. Any taxes due would relate to appreciation in the investments since the time of contribution. (There’s a separate complicating factor, called the pro rata rule, that can come into play when someone is converting IRAs that consist of aftertax and tax-deferred dollars.)

The Democrats’ House Ways and Means proposal, however, would put a stop to the backdoor Roth IRA maneuver by disallowing the conversion of aftertax dollars in IRAs starting in 2022. In other words, if someone contributed aftertax dollars to a traditional IRA next year or thereafter, those aftertax assets wouldn’t be eligible for conversion. 

Similarly, under the proposal, 401(k) participants who are making aftertax contributions to their company retirement plans would no longer be eligible to convert those assets to Roth, either. That would be the death knell of the “mega-backdoor Roth IRA” maneuver, whereby an investor makes aftertax contributions to a 401(k), then converts those funds to Roth, often inside the plan itself. If the aftertax contributions can never be converted, they’re much less attractive because the investor will still owe ordinary income tax on any investment earnings that rack up.

It’s important to underscore that the new rules only address aftertax contributions. Investors with tax-deferred IRAs--composed of money they haven’t yet paid taxes on--are still eligible to convert those assets to Roth. For example, if an investor has an IRA consisting of traditional 401(k) assets rolled over from a previous employer, those funds still would be eligible for conversions. However, the proposal would crack down in conversions by high-income taxpayers, albeit not for another decade. Starting in 2032, investors with high incomes (back to those $400,000 single and $450,000 married filing jointly thresholds) would no longer be able to convert IRA assets.

In what might be called “the Peter Thiel effect,” the proposal also cracks down on additional IRA contributions and imposes strict required minimum distribution rules on people with IRA and 401(k) balances of more than $10 million who have incomes of more than $400,000 (singles) and $450,000 (marrieds filing jointly). RMDs would apply to those supersize accounts even if the investor hadn’t yet reached the age of 72--the usual RMD threshold for self-owned (rather than inherited) IRA assets.

On the To-Do List
It rarely makes sense to act pre-emptively on a tax proposal before it becomes law, especially if those actions could trigger a tax bill. But in this case, people who had been in the habit of making aftertax contributions should keep a couple of things on their dashboard.

One is to take advantage of maximum allowable contributions to aftertax 401(k)s and IRA for 2021s (to the extent that their budgets allow), then convert those assets before year-end. In 2021, the IRA contribution limit is $6,000 for people under age 50 and $7,000 for those 50-plus. The total 401(k) contribution limit, including pretax or Roth contributions, matching dollars, and aftertax contributions, is $58,000 for people under 50 and $64,500 for those 50-plus. Those aftertax contributions could be off limits starting next year, but they're still allowed for 2021. 

Additionally, it’s now or never to convert any previous aftertax contributions that haven’t yet made it over to the Roth column. If the amount is sizable--you’ve made serial contributions that have racked up significant investment gains since contribution--be sure to get some tax advice to gauge the tax impact on your conversion. Ideally, you’d use non-IRA assets to pay any taxes due.