Backdoor Roth IRA – How Potential Changes May or May Not Affect You
Any saver can benefit from a variety of methods to minimize tax impacts while investing. One area currently in the news is the backdoor Roth IRA concept, a popular savings and investment method for high earners. Why? As covered by CNN and elsewhere, in conjunction with the Build Back Better bill, Congress is looking to make changes which would significantly affect the back door Roth IRA. Will this potential change impact you? Let’s dive into what the backdoor Roth IRA is, the proposed changes, and possible effects.
Backdoor Roth IRA – A Background
Roth IRA
In order to understand the backdoor Roth IRA concept, one must first grasp how Roth IRAs work. Named after former Senator William Roth, the Roth IRA was introduced in 1997 as an individual retirement account that is generally not taxed upon distribution under certain conditions. Here several of the more significant aspects of Roth IRAs:
- Direct contributions to a Roth IRA can be withdrawn tax and penalty-free at any time.
- Roth IRA distributions do not increase adjusted gross income. This is a major difference from a traditional IRA, where withdrawals are taxed as ordinary income.
- Roth IRA contributions can be made even if the owner participates in a qualified retirement plan such as a 401(k).
- Individuals under certain income limits are eligible to directly contribute to Roth IRAs. Here are the current limits:
- Single filers: Up to $125k (full contribution); $125–$140k (partial contribution)
- Joint filers: Up to $198k (full contribution); $198–$208k (partial contribution)
- Current annual contribution limits are $6k for individuals age 49 and below and $7k for individuals age 50 and over.
Backdoor Roth IRA
Based on the above income limits, high earners are excluded from directly contributing to Roth IRAs. However, many take advantage of a backdoor method to effectively obtain the same tax and investment benefits normally eligible individuals do. But how?
While high earners can’t make tax deductible contributions to traditional IRAs, they can make non-deductible contributions. These individuals subsequently transfer the non-deductible IRA contributions to a Roth, but they owe tax on the gains accumulated since the contributions. But if one immediately makes this conversion after making the non-deductible contribution, the individual minimizes tax implications. Indeed, there is very little time for the money to grow in this case.
Proposed Changes
Based on the Build Back Better bill the House recently passed, this backdoor method would disappear. As of right now, the bill would prohibit all individuals from converting after-tax contributions via the backdoor strategy. The bill also eliminates the similar mega backdoor Roth IRA method which is currently allowed via Roth 401(k)’s. You can read more about that here.
How Harshly Will This Affect You, If At All?
Some may say this matter meets a rather pure definition of a rich people problem. Many would feel blessed to be in the position where this change would impact them, and a portion of high-income taxpayers currently in this position probably realize that, as well. Regardless, we can’t ignore the impact of these proposed changes.
In general, these changes will not affect a large group of Americans who fall under the normal Roth provisions and/or don’t have the means or interest to participate in these backdoor strategies. High-income taxpayers who currently use backdoor methods for saving and investing will obviously be affected. But if these methods eventually disappear, it’s not the end of the world.
Regardless of income, it’s important to remember that tax experts are available to help with these situations. It’s just a matter of finding competent, trustworthy ones, which is no small task. Big picture, looking at challenges from different angles to find less obvious solutions is key. Indeed, I and many of you have done that in our hobby already.
Conclusion
I must underscore that passage of these changes into law is by no means assured. As it currently stands, the bill has passed the House of Representatives and is awaiting Senate consideration this month. It’s certainly possible lawmakers remove these aspects from the final version after negotiations. Even if they stick, though, it won’t affect a large portion of US taxpayers. Those that it does will have to look at other options, and hiring expertise would help. Do you use any of these backdoor methods for saving? What’s your take?
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A married couple who jointly earn $200,000 a year are hardly “the rich”. They are upper middle class and not only at the top end of that group. The true rich wouldn’t use a Backdoor Roth to protect their wealth. When you convert your 401K (tax deferred account) to a Roth after you retire (at that time because you were not eligible at that income level to contribute to a Roth while you worked) you pay taxes on the entire amount you convert. It’s added to your Ordinary Income (same as Wages) and taxed at that tax rate – whatever tax bracket that person is in. There is no Long Term Capital Gains tax rate on the earnings that were realized in that 401K over the years, as a person would have with an After-Tax investment account. It’s all taxed as Ordinary Income. The rich, on the other hand, have far better ways to protect their wealth than by paying full ordinary income tax rates on their wealth just so that they can grow it tax free ever after their retirement date. So the Backdoor Conversion is not a tool “the rich” would ever use. It would be laughable to even consider paying that much tax given all the other, far better, tax shelters available to them. And those were put in place, by the way, by Congress (agreed to by both parties, who still agree with the principle of permitting such shelters) to give “the rich” an incentive to invest lots of money in certain kinds of things that are considered, by Congress, to be in the best overall interest of the country. On the other hand, the slightly-upper to fully-upper middle class can take advantage of the backdoor Roth conversions – but only after paying the full ordinary income tax on the total dollar value of the funds they are converting. After that, any further gains made on those (now fully taxed) investments will grow tax free the rest of their lives. These are mostly hard working professionals, like engineers, pharmacists, front line and middle managers, college instructors, etc. who spent years studying and working their way up afterwards to reach the point where, as a married couple, they exceeded the $200k/year joint income level. Accumulating retirement wealth is not always easy for people at this income level – again, these are not “the rich” – and the Backdoor Roth is one of very few tax breaks available to this group of people. Especially since, without it, they pay full tax on their 401K once they start taking money out of it in retirement. The only “tax break” in a 401K, without a backdoor Roth, is that presumably in retirement you are in a lower tax bracket than you were in when you were working. But that’s not always a significantly lower tax bracket – in which case they may have been better off just saving money in a regular after-tax investment account and benefitting from the lower Long Term Capital Gains tax rate for investment earnings. You lose that when you do a backdoor Roth conversion. So there’s nothing to feel resentment about for upper middle class people having that one marginally useful tax break. The Rich will remain the ones, far over joint $200,000 per year earners, who can get the real tax shelters. It’s not the people who can benefit from the Backdoor Roth Conversion. Those are just the upper half of the middle class. Who pay a lot of taxes throughout their careers – and when they retire if they do Roth Backdoor Conversions. This article used the term “high earners” to describe these people. To me that sounds like “the rich”, so it’s a misleading article, IMO.
$200 grand a year puts a household in the top 10% Hard to see how that is middle class?!
The reason to close the loophole is not a resentment/envy one, that’s just a knee-jerk obfuscation used in defense of the current work around. It should be closed because it is not inline with the design and purpose of the Roth accounts.
The group that the closure of the backdoor Roth hurts the most are the HENRYs – “high-earners, not rich yet”, specifically those that spend long years in school/training, accumulating debt and with a net worth ballooning in the wrong (negative) direction. If this group sounds familiar, it’s because it is – your friendly neighborhood doctor who spent the past 21 months and counting battling out this pandemic while most other 4-year college grad professions got to work from the comfort of their homes.
Let me explain. You have a bunch of young physicians who spent the better part of their mid-late 20s accruing a quarter-million of student debt all while their 4-year college grad peers have been adding to their net worth in tax-advantaged and compounded manners like the Roth IRA. And then all of a sudden, these folk emerge from residency/fellowship after at least 11 years of school/training, and start earning a salary that immediately renders them ineligible for these tax advantaged accounts. And it is rather disingenuous to spend the past 21 months calling doctors heroes, only to shut them out of the same wealth creation tools their peers have been taking advantage of for a better part of a decade.
I agree that the Roth IRA (and many other aspects of the tax code) should be reformed, but it cannot be done so in such a slapdash manner, and need to consider the peculiarities of the groups of people being affected by it. Perhaps a better and fairer way would be to allow a set number of years or a set dollar amount of Roth contributions for every person.
It’s a matter of when you get to eat your cake. Retirement savings allow you to eat your cake later when your ability to earn has likely declined. There is no restriction on how much (or how little) you can save for retirement. There are reasonable limits on how much of a discount you can get today to save for tomorrow.
You’re right – this absolutely is a rich people problem. Let’s be realistic here, about what percentage of Americans will be affected by the closing of this loophole? If it’s less than 20%, it’s pretty obvious that it’s good for the country as a whole. The thing is, I’d bet the numbers are more like 2-10%. Now why are we currently going out of our way to give rich people even more money? The U.S. economy is built on consumer spending so if you want a route that makes rich people richer without hurting normal people, find a way to put more money in the pockets of regular people who will buy things and keep the economy going rather than a rich person who will only see a small increase in their portfolio value. Doing that makes moral, patriotic, and financial sense.
What must be understood is that this is an attack on the middle class. Upper middle class, sure, but middle class nevertheless. Folks like Buffet, Gates, Dimon, etc. don’t feel any pain from removing a Roth back door at all. Small business owners, professionals, etc. on the other hand benefit greatly from it. Attacking the middle class- which pays nearly all of the US income tax collected- should not be tolerated by any of us.
Americans treat the middle class like they’re people who work 800 hour weeks and dumpster dive for their dinner. It’s caused politicians to grossly undertax the middle class compared to other developed nations. If you’re on the right, a flatter tax means a higher tax on the middle class. If you’re on the left, a larger welfare state requires a higher tax on the middle class. Either way, the US should stop babying the middle class.
Having said that, the backdoor Roth isn’t the thing to go after! If anything, all income limits on IRAs should be removed so you wouldn’t need a backdoor. Tax it more before it goes in or after it comes out but don’t penalize people, even rich people, for the mere act of investing.
Many folks overestimate the earnings of the “middle class” Some go so far as to say at times that this group is shrinking. Of course, that is impossible by definition unless population shrinks.
The back door loop hole should be closed, it doesn’t affect the middle class. Even if it did, it does not match the intent of after tax retirement plan design. There is no law or limit to saving for retirement, never has been. Folks just get spoiled by the tax discounts offered by advantaged plans.
Ahh, I see… yes, getting ‘spoiled’ by wanting to save for retirement, especially for younger folks who do not have pensions or possibly social security in the future due to insolvency. Yes, how dare folks try and be responsible to save for their future instead. What spoiled brats.
It’s a matter of when you get to eat your cake. Retirement savings allow you to eat your cake later when your ability to earn has likely declined. There is no restriction on how much (or how little) you can save for retirement. There are reasonable limits on how much of a discount you can get today to save for tomorrow.
Now that the CBO has said the REAL cost of this build back better fiasco is 3 TRILLION – not “free” as bumbling Joe and nancy have said, hopefully this will put the final nail in the coffin of this bill