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
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- Direct contributions to a Roth IRA can be withdrawn tax and penalty-free at any time.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.
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.
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?