Backdoor Roths one step closer to demise; regular Roth conversions on 10-year leash for higher earners

One of the most lucrative tax loopholes for the wealthy likely has only two weeks to live, thanks to draft legislation released by the Senate on Dec. 11. For less-affluent investors, a version of the benefit gets another decade of life.

Come 2022, the hatchet would drop on the ability of all investors to sidestep their way into Roth accounts, tax-free plans that are a favorite strategy among financial advisors for generating retirement wealth for clients. Those so-called backdoor Roth conversions are one step closer to an imminent demise because Senate tax writers left in place a proposed ban on them in the $1.8 trillion tax-and-spending bill passed by the House of Representatives last month.

Regular, straightforward conversions that don’t involve the “backdoor” route would still be allowed — a lucrative opportunity, given that there are no income limits on Roth conversions. But come 2032, higher earners would be locked out of those as well. Another proposed curb in the Build Back Better bill would come earlier, in 2029, and ban people who make $400,000 ($450,000 if married) and who have total retirement savings over $10 million from contributing to IRAs.

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“You can still do a backdoor conversion between now and Dec. 31, but the window is very likely to close,” said Robert Polans, a founding shareholder of accounting and tax consulting firm Drucker & Scaccetti in Philadelphia. “Backdoor Roths are dead.”

Floodgates
Roth plans began life more than two decades ago as a savings tool for middle-income earners — a taxpayer today has to earn under $140,000 (under $208,000 if married) to open a Roth individual retirement account.

In their basic form, taxpayers within those income limits can open a Roth account and put in after-tax dollars — up to $6,000 a year, plus an extra $1,000 if they’re age 50 or older. Or they can convert their traditional IRA or 401(k) to a Roth. When converting, the taxpayer owes income tax on her pre-tax contributions and earnings, but the future gains grow tax-free. Rules and tax bills can get complicated, as retirement expert Ed Slott explained here, depending on what a 401(k) allows and whether the dollars being converted are pre-tax or post-tax. One maneuver involves rolling 401(k) money into a traditional IRA, then converting that plan to a Roth.

By contrast, a traditional IRA is funded with dollars on which taxes haven’t yet been paid. So when its owner makes withdrawals or takes distributions, she pays ordinary income tax rates on the gains. Traditional IRA contributions (the same levels as for Roth IRAs) are deductible, but Roth ones are not.

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Crucially, IRS rules don’t limit how much of a traditional IRA or 401(k) can be converted to a Roth or who can make the change. And so the Roth floodgates opened to high earners in 2010 when a new law removed the income restrictions on who could convert one, allowing wealthy people whose income exceeds the threshold for Roth contributions to roll over their sizable traditional IRAs into Roths. Pre-tax amounts that are converted face ordinary income tax. After-tax amounts that are converted face ordinary tax on their gains at the time of conversion.

Thus was born the so-called backdoor Roth conversion. The “backdoor” refers to the sidestepping of the income limits.

When things went ‘mega’
Affluent earners can stuff the piggy bank further by making after-tax, non-deductible contributions to their traditional IRAs, then rolling them into a tax-free Roth. While the IRS caps an employee’s pretax contributions to a 401(k) at $19,500 (plus an extra $6,500 if age 50 or older), it also allows up to $38,500 in after-tax contributions. This year, total contributions can’t exceed $58,000.

In 2014, things got “mega” for high earners when the IRS ruled that investors could roll their after-tax 401(k) contributions into a tax-free Roth. Thus was born the “mega-backdoor” Roth conversion. After-tax amounts that are converted face ordinary tax on their gains at the time of conversion.

Relatively few Americans have sizable retirement plans. Just over 28,600 taxpayers held IRAs, both traditional or Roth, with balances of at least $5 million — the IRS’s definition of a “mega” account — in 2018, according to a nonpartisan Joint Committee on Taxation study last July. Of that group, nearly 3,000 taxpayers had Roths.

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The study didn’t indicate if those were the product of conversion, but their size would seem to indicate that they are, given the direct contribution limits to regular Roths. By contrast, more than 7.1 million ordinary-income taxpayers made direct contributions to Roths in 2018, according to the most recent IRS data.

Which means that in the emerging tax bill, “Roths are minorly dead,” said Slott, who is based in Rockville Center, New York, and trains financial planners on retirement planning. He estimated that “maybe 5%” of all conversions are of the backdoor variety, meaning by wealthier earners. “So just live with it.”

More significant, Slott said, is the 10-year window to continue regular conversions, which can run into millions of dollars and more. “You’re probably going to accelerate those before 2032. Congress has given you a heads up.”

Polans said that many high net worth clients typically wait until the April return filing deadline to fund Roth contributions for the prior year. That won’t work this time. “The time to fund an IRA with after-tax contributions and convert it to a Roth is now,” Drucker & Scaccetti wrote in a Dec. 14 note.