An incredibly wise man, Benjamin Franklin, once said, “In this world nothing can be said to be certain except death and taxes.” While there isn’t anything we as financial planners can do about death, one of our main goals is to help our clients reduce their total lifetime taxes paid.
One of the best ways to accomplish this is to contribute money to a Roth retirement account (either a Roth IRA or a Roth 401(k)). The trouble with this is that not everyone is eligible to contribute to a Roth IRA directly or has an employer that offers a Roth 401(k) option. In these instances, another avenue to pursue is evaluating whether it makes sense to do what’s called a backdoor Roth contribution instead.
While making this contribution is perfectly legal, as the name implies, a backdoor Roth contribution is only used if someone is unable to make a Roth contribution directly. Whenever new tax laws are proposed, financial planners everywhere are in a state of trepidation wondering whether the rules allowing backdoor Roth contributions will be revoked. Well, this is the year it may come to pass. On September 13, the House Ways and Means Committee released its proposal for tax law changes, which includes text to end the backdoor Roth. (Links to the specific text of the changes are here and here).
It is important to note that these proposals are currently just that, proposals, and have not officially become law. However, this change, among others, may have a significant impact on those who are currently making these contributions if the law goes through. Here is what you should know about these contributions, what is changing, and what you should consider before year-end if you are making these contributions.
Roth IRA Rules
The reason many financial planners love Roths is because of how they are taxed. The way these retirement accounts work is that you put in post-tax money today, it grows tax-deferred (you will not pay any taxes on investment income while it is in the account), and when you withdraw the money later it comes out tax-free. The trade-off for the tax-free growth is that you do not get a tax deduction for your original contribution, unlike a contribution to a regular 401(k) account, for instance.
While this tax-free growth is great, unfortunately, not everyone is able to contribute to a Roth. To make a full contribution to a Roth IRA in 2021, you must have income below certain limits. The full contribution amount this year is $6,000, and there is a $1,000 catch-up contribution ($7,000 total) for those who will be 50 or older by the end of the year.
If your income is too high to contribute to a Roth IRA, you may be able to make a Roth 401(k) contribution if your plan allows it (not all plans do). There are no AGI (Adjusted Gross Income) limits currently for contributing to a Roth 401(k). However, if you do that, you will forgo the tax deduction from a regular 401(k) contribution. Your total regular and Roth 401(k) contributions cannot exceed $19,500 in 2021 ($26,000 if you’re over 50). The best type of account to contribute to depends on your personal tax situation, and it is best to work with a qualified tax planner or financial professional to help with this.
Lastly, to contribute to either account, you need to have earned income. This means you need to have income that comes from some form of gainful employment (either working for an employer or being self-employed). You cannot make a Roth contribution if you only have investment income or income that comes from retirement account withdrawals, as a couple of examples.
How Does a Backdoor Roth Contribution Work?
A backdoor Roth contribution is something that can be used when your income is too high to make a Roth contribution directly. The way it works is that you first contribute to a regular IRA using post-tax dollars and receive no tax deduction for making the contribution. You then convert the money contributed from the regular IRA to a Roth IRA. Since the money you contributed to the regular IRA was already taxed, you do not pay taxes on that amount again. However, any growth from the contribution does get taxed as regular income.
Example: Mike is single and his AGI is $175,000 a year. His income is too high to make a Roth contribution directly, so on January 15 he makes a full $6,000 contribution to his regular IRA and invests it. He receives no tax deduction for the contribution. The value of the account grows to $7,500 on November 1 and Mike decides to convert it to his Roth. Since $6,000 was already post-tax money, he will only owe taxes on the $1,500 of growth ($7,500 minus $6,000), not the full amount converted. Now that the funds are in the Roth, they will continue to grow tax-free going forward.
Another caveat to a backdoor Roth is that all contributions are prorated among all your IRAs (Individual Retirement Accounts), (NOT 401(k)s), between pre-tax and post-tax money. A backdoor Roth is most effective when someone’s income is too high to make a Roth IRA contribution directly, but they don’t currently have much, or any, money in their regular IRAs.
Example: Mary has $500,000 in her 401(k) account, $5,000 in one IRA that was all a post-tax nondeductible contribution, and $5,000 in another IRA that is all pre-tax money. Mary decides that she wants to convert $1,000 from the first IRA that was all a post-tax contribution. Half her IRAs are post-tax contributions, the other half are pre-tax money, and the 401(k) is not considered. Even though she converted money from the account with post-tax contributions, the conversion is considered to come prorated from each IRA, making $500 taxable as income to her and $500 as a return of post-tax contributions.
What’s Changing With the Proposed Legislation?
The key change is that the new proposed law prohibits conversions of any post-tax dollars contributed to a retirement account, effectively putting the final nail in the coffin of the backdoor Roth. Once again, this is currently just proposed legislation and is not officially law. However, if this portion passes, 2021 may be the last year for some people to make this kind of contribution.
This potential legislation change also prohibits backdoor Roth 401(k) contributions. These contributions work the same way as the IRA. You contribute after-tax money, in addition to your regular contribution, to your 401(k) if the plan allows it. Then you convert the after-tax money in your 401(k) to the Roth 401(k) side by moving over either just the after-tax money (resulting in no new tax liability) or a prorated amount between the after-tax contribution and the earnings on that portion.
These two excellent methods for higher-earning individuals to put money into a tax-free account will be much more limited if this law goes through.
What Should You Do to Prepare?
Although the backdoor Roth is not gone yet, there is a good chance that this provision will pass. With this in mind, we highly suggest that anyone with post-tax money in their IRA or 401(k) watch this legislation closely and be ready to act by year-end.
If you have regularly been making backdoor Roth contributions, you will want to make sure you convert those amounts to a Roth before year-end. In past years if you forgot to convert, you could always do it the following year. You may have owed more (or less) in taxes depending on how the investments did, but the only ramification was that the conversion was pushed out to a new tax year. Starting in 2022, this may not be an option and you may lose much of the benefit of the contribution. Growth of the account continues to grow tax-deferred, but instead of being tax-free, future distributions are taxable to you upon withdrawal.
While getting post-tax money out of retirement accounts is a noble goal, it gets more convoluted if you have a large IRA relative to the amount of post-tax money. For instance, if you had a $100,000 IRA and only $5,000 is a post-tax contribution, it does not make sense to convert the entire account to get all the post-tax money out since you will be taxed on an additional $95,000. However, depending on the account balance and your personal tax situation, it may warrant a closer look at how much to convert, if anything. We strongly suggest working with a qualified tax professional or financial planner to review your situation.
Also, if you are someone who normally waits until the next year to make your nondeductible contribution, you should consider making it this year and converting before year-end. The IRS (Internal Revenue Service) allows for prior year Roth IRA and regular IRA contributions before the tax filing deadline. While you are still allowed to make a nondeductible contribution for 2021 up through April 15 of 2022, you may not be able to convert that after-tax money to a Roth if this version of the American Families Plan becomes law. So, make your 2021 contribution now and convert before the year is out if you can!
The backdoor Roth, beloved by many financial planners, may soon be ending. Although this is not law yet, there is a good chance this provision will be passed in 2021. If you’re someone who makes backdoor Roth contributions, it is important that if this law passes you act before year-end to ensure that your post-tax contributions make it into your Roth.
There were many more changes proposed in the legislation besides eliminating future backdoor Roths. In the coming weeks, and especially when any new legislation passes, we will be reviewing the tax law changes and their impact on individuals and families. For help reviewing your personal tax and financial situation, we encourage you to reach out to our team.
Nick Prigitano, CFP® is an advisor at Milestone Financial Planning, LLC, a fee-only financial planning firm in Bedford NH. Milestone works with clients on a long-term, ongoing basis. Our fees are based on the assets that we manage and may include an annual financial planning subscription fee. Clients receive financial planning, tax planning, retirement planning, and investment management services, and have unlimited access to our advisors. We receive no commissions or referral fees. We put our clients’ interests first. If you need assistance with your investments or financial planning, please reach out to one of our fee-only advisors.