Is the Backdoor Roth Still Legit?

The backdoor Roth maneuver has become part of Tax Planning 101 for higher-income investors, enabling them to indirectly make Roth IRA and even Roth 401(k) contributions. But the Build Back Better Act under consideration in Congress would eliminate the loophole.

With the fate of backdoor Roths still up in the air, should investors who were in the habit of making these "backdoor" contributions continue doing so? Is there any likelihood that Congress would make the closure of the backdoor Roth retroactive, thereby forcing investors to undo their backdoor maneuvers?

That's unlikely, according to many financial and tax-planning professionals. Given that these contributions and conversions are currently allowable, they've been urging their clients to go ahead with them until the law officially changes.

Background on the Backdoor

The backdoor Roth IRA was born in 2010, when Congress lifted the $100,000 income limit that had previously been in place for IRA conversions. That change enabled investors who earned too much to contribute to a Roth IRA directly to contribute to a traditional IRA (where income limits don't apply so long as you don't deduct the contribution), then convert to a Roth after that. Voila, "backdoor" Roth IRA contributions!

And while conversions can trigger an income-tax bill, getting money into a Roth via the backdoor is generally pretty tax-efficient. As long as the investor converts the traditional IRA to Roth before it racks up big gains (and the investor doesn't have a lot of other traditional IRA assets composed of pretax dollars), the conversion to Roth won't entail much of a tax bill.

High-income investors have been happily converting for more than a decade, using the strategy to build assets in Roth IRAs, which enjoy tax-free withdrawals and also skirt required minimum distributions. Some investors had also been availing themselves of what's called the "mega-backdoor Roth IRA," which involves making aftertax contributions to a 401(k) and then converting those contributions inside the plan to Roth. For high-income heavy savers, that strategy carries a major advantage in that it allows them to get as much as $61,000 in total contributions into the company retirement plan in 2022. (That threshold is even higher for people over age 50--$67,500.) Large 401(k) plans had been increasingly adding aftertax 401(k) contributions and automatic in-plan conversions of those aftertax amounts. Although Roth 401(k) withdrawals are subject to required minimum distributions, assets in those accounts can be rolled over to a Roth IRA for RMD avoidance.

Yet, while it's popular, the future of the backdoor Roth strategy was called into question last year with the introduction of Build Back Better. The main goal of the bill is to fund social programs and initiatives to combat climate change, and the bill also entailed some changes to the tax code, mainly loophole closures and other measures aimed at raising taxes on high-income taxpayers. In that vein, the bill included a provision that would ban conversions of aftertax dollars in IRAs and 401(k)s. Without the ability to convert, contributing aftertax dollars to an IRA or 401(k) would be much less attractive and arguably wouldn't make sense for most investors, as I noted last year.

What Now?

Of course, Build Back Better didn't pass in 2021. That means that it's perfectly legal to go ahead with backdoor Roth contributions for 2022, too. But is there a risk that Build Back Better could pass later this year and that Congress would make the ban on aftertax conversions retroactive to the beginning of this year?

Aron Szapiro, head of retirement studies and public policy for Morningstar, thinks that's highly unlikely. He has been a skeptic that the bill would quash the backdoor Roth at all, noting that the revenues associated with eliminating the loophole would be modest and that one or more senators would like to kill this provision. And he puts the likelihood of a retroactive ban on aftertax contributions at "close to zero."

"Such an approach could actually end up costing the government money to try to enforce such an action, issue new forms, and promulgate new guidance, even if it weren't scored that way by the Joint Committee on Taxation," he said. That runs counter to the goal of closing some of these loopholes: raising revenues.

Jeff Levine, chief planning officer for Buckingham Wealth Partners, acknowledges that a retroactive ban on conversions of aftertax dollars isn't out of the question, but he agrees that that scenario is "highly unlikely." He points out that such a backward-looking prohibition would be unpopular with taxpayers as well as financial firms. He also shares Szapiro's view that making the provision retroactive would pose logistical challenges. That's because the Tax Cuts and Jobs Act of 2017 eliminated what had been called "recharacterizations" of assets that had been converted to Roth. If investors went ahead with contributions of aftertax dollars to their IRAs and 401(k)s in early 2022 and converted them to Roth inside their accounts, what mechanism would they use to convert them back if those conversions were disallowed?

In short, the backdoor strategy isn’t risk-free; it makes sense to ask your tax and/or financial advisor if such a strategy makes sense in your situation. (As always, the pro rata rule is worth keeping an eye on, as it can affect the taxes due on these conversions.) But given that backdoor Roths are one of the few mechanisms that higher-income heavy savers can use to achieve tax-free withdrawals and avoid RMDs in retirement, many such savers are apt to conclude that it’s a risk worth taking.