Many of you are familiar with backdoor Roth IRA and “Mega“ backdoor Roth IRA contributions. The strategy is commonly used for individuals making more than $140,000 and for married couples making more than $208,000. If you are above the income limit for a Roth IRA, you can make an after-tax contribution to a Traditional IRA and convert the funds to a Roth IRA each year. For the first time since 2010, the rules may be changing.
The Strategy
If you are using the “Mega” backdoor Roth conversion strategy, you are making after-tax contributions to your employer’s 401k plan and converting the funds to a Roth IRA through an in-service distribution each year, which is rarely allowed, or after age 59 ½ in one lump sum. This makes sense for the individual that has maxed out his/her pre-tax investment options, executed a backdoor Roth IRA contribution, and whose remaining savings would otherwise go to a basic brokerage account (in which case the gains would be taxed as a long-term capital gain at 15% or 20%). Several things must align for the “Mega” backdoor Roth IRA to work. To execute a “Mega” backdoor Roth IRA, your 401(k) or 403(b) plan must allow for after-tax contributions and either In-Service Distributions or In-Plan Rollovers to a Roth. The total contribution limit for both employee and employer contributions to 403(b) plans under section 415(c)(1)(A) is $58,000 per year and the same is true for a 401k. If you contribute the maximum pre-tax contribution of $19,500 as an employee and receive an employer match of $10,000, you are technically able to make an after-tax contribution of $28,500 to your 401k or 403b. By converting the $28,500 to a Roth IRA immediately, you can invest the money in a place where the growth is tax-free. To many of you, this sounds great. Not only can you do the $6,000 contribution to a Traditional IRA and convert that to a Roth IRA each year, but you can also contribute an additional $28,500 to your 401k or 403b and convert that to a Roth as well.
Obstacles to “Mega” Backdoor Roth Contributions
However, this idea is not without caveats. Though this is allowed by the IRS, your employer’s plan may not allow it. Retirement plans must pass plan testing requirements and if a plan receives too many after-tax contributions from highly compensated employees and not enough from non-highly compensated employees, the plan will hit the nondiscrimination limits implemented by the IRS. To avoid this issue, many employers will not allow employees to make post-tax contributions outside of a Roth 401k or 403b option. We also find that most employers do not allow for In-Service Distributions before age 59 ½ and such would be needed to convert the after-tax contributions to a Roth IRA each year. In rare situations, this may be an option for a client - especially one with some level of control over what is and is not allowed under the plan. For example, if you are an owner or partner in the group, you may have a say in what the plan allows.
The New Tax Proposal
The reason I’m writing about the backdoor Roth IRA and “Mega” backdoor Roth IRA is because the House of Representatives Ways and Means Committee believes both loopholes are typically executed by the wealthy and should be closed. In the committee’s recent proposal to raise funds for President Biden’s 3.5 trillion spending plan, several changes were recommended and eliminating the backdoor Roth IRA was one of them. The bill “prohibits all employee after-tax contributions in qualified plans and prohibits after-tax IRA contributions from being converted to Roth regardless of income level, effective for distributions, transfers, and contributions made after Dec. 31, 2021,” reports the House Ways & Means Committee. If the bill is approved, single filers making $140,000 or more and married couples making $208,000 or more would not be able to receive the tax break the backdoor Roth conversions offer going forward. All Roth conversions of after-tax Traditional IRA and after-tax 401k contributions would be eliminated regardless of AGI levels beginning on January 1st, 2022. All Roth IRA conversions of pre-tax traditional IRA and pre-tax 401k contributions would be banned starting in 2032 for single taxpayers who earn more than $400,000 and married taxpayers with incomes over $450,000.
Some are speculating that a change may be made prior to approval as it’s been argued that this causes a tax increase for households with less than $400,000 of income. Biden vowed this group would not have a tax increase; therefore, many are asking him to keep his promise. However, another case is being made from the other side that this would not be a tax increase because it is not imposing a higher tax or a new tax; rather this is the result of a tax break being removed. Regardless, the backdoor Roth conversions enjoyed by many since 2010 may be coming to an end.
What Should You Do
With that in mind, it would be wise to ensure that your Traditional IRA is being funded with the maximum allowed prior to December 31st, 2021 if you intend to execute the backdoor Roth contribution for the 2021 tax year. Though IRA contributions can be made until the tax deadline in the following year, the rule states it will be enforced for any transfers, distributions, or contributions made after December 31st, 2021. If the bill is passed, our team will be vigilant to process and confirm all Roth conversions before December 31st.
Of course, it’s wise to be certain your Traditional IRA is ineligible for tax-deductible contributions before employing this strategy. If you are not employed and are without a retirement plan, it may be that you can qualify for tax-deductible contributions to a Traditional IRA regardless, even if your income exceeds the limit. For the average physician, I would always recommend maxing out pre-tax contributions through various retirement plan options before moving on to after-tax retirement accounts that grow tax-free. I would expect the tax rate you are avoiding today is greater than the tax rate you will eventually pay at the point of distribution when we are able to selectively withdraw only what is needed. Assuming tax rates do not increase significantly, most physicians and dentists will likely pay less in taxes if they maximize pre-tax contributions receiving tax-deferred growth before maximizing post-tax contributions receiving growth that is tax-free.
The proposal could certainly change or may not be implemented at all, but I believe it’s wise to remain alert and aware of potential changes on the horizon.