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What to do if Congress Shuts Back Door on Roth IRAs

Retirement Planning > Saving for Retirement > IRAs

What to Do if Congress Locks the Back Door on Roth IRAs

By Roger Wohlner

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What You Need to Know

  • Proposed legislation would kill the backdoor Roth and Mega backdoor Roth strategies if passed.
  • This legislation would also eliminate all Roth IRA conversions for those earning over $400,000 after Dec. 31, 2031.
  • Clients who use the backdoor and mega backdoor Roth strategies will need to do some planning prior to year-end.

The House Ways and Means Committee recently passed $2.1 trillion in tax hikes that will help fund President Joe Biden’s American Families Plan. Among their proposals are the elimination of backdoor Roth and mega backdoor Roth IRA conversions. Both of these provisions could affect your clients who earn too much to contribute to a Roth IRA and those who want to ramp up their Roth account balances.

Backdoor Roth IRA Strategies

A mega backdoor Roth is a situation where your client can contribute up to $38,500 on an after-tax basis to their employer’s 401(k) plan, if the plan allows for these contributions. At some point, your client will roll this money over to an IRA and convert to a Roth IRA plan or to a Roth 401(k) account within the plan if one is offered and in-plan conversions are allowed. Rollovers with a conversion to a Roth IRA would be made either when they leave the company or while they are employed if the plan allows in-service withdrawals.  

The backdoor Roth IRA conversion is a technique where investors who earn too much to contribute directly to a Roth IRA make after-tax contributions to a traditional IRA and then convert the contributed amount, and perhaps other money in the account, to a Roth IRA. 

Take Action by Year-End

The proposed legislation would end the ability to convert after-tax contributions in both 401(k) plans and traditional IRAs to a Roth after Dec. 31, 2021, effectively killing both of these options.  

Clients who have been making after-tax contributions to their 401(k) plan to fund a mega backdoor Roth conversion need to make some decisions this year. 

If their plan allows for the conversion of this money to a Roth 401(k) account within the plan, this needs to be done prior to Dec. 31, 2021, if the legislation passes as is. Note that any earnings on these after-tax contributions will be taxable upon conversion. If the plan allows for in-service withdrawals in order to roll this after-tax money to an IRA and convert to a Roth, your client will want to consider doing this by the end of the year. 

If none of these options are available to your client, the after-tax contributions would be stuck in the plan until they leave the company. Unless this happens prior to Dec. 31, 2021, they will lose the opportunity to convert this money to a Roth if the proposed legislation passes.  

For clients who may want to make an after-tax contribution to a traditional IRA and do a backdoor Roth conversion, this also needs to be done by Dec. 31 of this year if this legislation passes.

10-Year Roth Conversion Window

The proposed legislation contains limitations on conversions of traditional IRA money based on pretax contributions after Dec. 31, 2031. For those earning $400,000 or more (or $450,000 for married filing jointly) the ability to do a Roth conversion will be completely eliminated after this date.  

The 10-year window on Roth conversions is a good reason for you and your clients to revisit the timing for Roth IRA conversions to ensure that they are able to convert a desired amount over the next 10 years if they will be in a higher income bracket after the window closes. 

Backdoor Roth Alternatives

While there is no way to replicate the backdoor Roth, there are other ways to accumulate assets that won’t be taxed in retirement.

Roth 401(k) 

Clients who have the option can contribute to a Roth 401(k) in order to accumulate assets in a Roth account. The proposed legislation does not limit these contributions, and the money can be rolled over to a Roth IRA when your client leaves their employer. 

In many cases, a Solo 401(k) can offer a Roth option as well. This would work in the same fashion as a 401(k) offered via an employer as far as the employee contribution component. 

Health Savings Account (HSA) 

HSAs are a great vehicle for clients who have access to a high-deductible health insurance plan. Health savings accounts allow for pretax contributions and withdrawals to cover eligible medical expenses are tax-free. 

HSAs can act as another retirement account in that the money contributed to the HSA can be carried over from year to year if not used. This makes an HSA a great way to save for medical costs in retirement, essentially making it a tax-free retirement savings account. Many HSAs allow the money to be invested. If the money is not used for medical expenses in retirement, it can be withdrawn just like a traditional IRA with taxes due on the money. 

Contribution limits for an HSA are: 

  • Individuals can contribute $3,600 for 2021 and $3,650 for 2022.
  • Families can contribute $7,200 for 2021 and $7,300 for 2022.
  • Those over age 55 can contribute an extra $1,000. 

Life Insurance 

A whole life insurance policy, along with some other types of cash value life insurance, is another way to build tax-free income in retirement. This is more complex than a backdoor Roth to be sure, but if this is a fit for your client this can be an alternative. I’m confident that this will be promoted extensively if the Roth-related provisions of the proposed legislation pass. 

Essentially, your client would purchase the life insurance policy. Part of the premium funds the growth in cash value. They can withdraw the portion related to their premiums tax-free and take a policy loan against the rest of the cash value that will have accrued from dividends. The additional withdrawals will serve to reduce or eliminate the death benefit. Upon their death, the death benefit passes to their heirs tax-free. 

There are a number of cautions and caveats to this approach, including ensuring the client doesn’t withdraw too much so as to create a modified endowment contract situation. Additionally, the cost of the premiums and the client’s need for the death benefit should also be considered. 

Conclusion

The Democrats’ proposed legislation effectively ending the mega backdoor Roth and the backdoor Roth is not a certainty, but advisors whose clients use these techniques need to stay on top of this to determine if action is needed regarding either of these options before the end of 2021. Beyond this, it is important to discuss other options with your clients going forward. 

Image: Chris Nicholls/ALM, Adobe Stock

Roger Wohlner

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