Closing the Back Door: What Could Happen to Roth Conversions Under the Build Back Better Act
As the end of the year draws near, lawmakers in Washington are considering plans to limit “backdoor” and “mega-backdoor” tax saving strategies for certain high-income taxpayers. In September, the House Ways and Means Committee approved changes as a way to fund the $3.5 trillion Build Back Better Act.
Financial advisors often employ a “backdoor” Roth strategy for people who are ineligible to make regular Roth IRA contributions because their income is too high. At present, anyone can convert any amount of money from a traditional IRA to a Roth – no income or contribution limits exist. You do, however, risk a large tax bill on the rollover if you include pre-tax contributions you’ve deducted or earnings from investments sitting in your traditional IRA.
A “mega-backdoor” Roth contribution is possible for those who have a 401(k) at work. Under the current law, taxpayers in this situation could place up to $38,500 in after-tax dollars into their 401(k) (if their plan allows it) and subsequently roll the money into a mega-backdoor Roth. This option also carries the risk of a higher tax bill because it can be quite complex.
If the Build Back Better Act becomes law, it could eliminate Roth conversions for both IRAs and employer-sponsored plans for single taxpayers (or married taxpayers who file separately) with taxable income over $400,000, married taxpayers filing jointly with taxable income of more than $450,000, and heads of households with taxable income over $425,000. (All of these are indexed for inflation.) According to a summary released by the House Ways and Means Committee, the provision would apply to all conversions made after Dec. 31, 2021.
Prepare Now
If you’ve made backdoor Roth conversions in the past, the only deadline you’ve had to worry about is the deadline to make your non-deductible traditional IRA contribution, which, under the usual circumstances, is April 15th of the following year. You could make the Roth conversion any time. However, if the proposed changes become law, you’ll need to act by Dec. 31 if you plan to do a conversion for this year.
After Dec. 31, you’ll want to discuss other tax-free options to grow your nest egg with your financial advisor if backdoor and mega-backdoor Roth conversions go away. And, since the proposed legislation contains more changes to retirement plan rules as well as tax increases for high-income individuals, you’ll want to discuss how those changes affect your situation as well.
As Democrats work to get enough votes to pass the bill in the house, it wouldn’t be a surprise to see modifications to the current version. A lot could happen between now and the end of the year, but it never hurts to be prepared in case the sections affecting your financial planning strategies pass without changes.
In the meantime, our team of advisors, tax specialists, and estate planning professionals is monitoring the activity in Washington, and we’ll keep you apprised of what’s ahead. To watch our recent webinar on the Build Back Better Act, you can watch it here.
Is a Roth Conversion Right for You?
Converting some of your retirement accounts into a Roth now could shield you from future tax increases and provide valuable tax diversification. Contact us to learn how.
Will V. Gunlicks
Financial Advisor / Team Lead
CFP®