September 24, 2021 | By Jessica Goedtel, CFP®
11/5/2021 update – Sigh. It’s back.
10/29/2021 update – Yesterday’s updated reconciliation bill has removed this provision, so backdoor Roth conversions are still allowed. I won’t be surprised to see it come up again in the near future, but the strategy is safe at least for now.
New proposed tax legislation was recently presented that covers a range of changes, including increasing capital gains and other taxes for high earners (over $400k each year) to closing a loophole that allowed cryptocurrency holders to generate losses. Most of these rules are aimed at a very small portion of the population.
One item was targeted though that could impact how you’re able to save for retirement: the backdoor Roth IRA (and its cousin, the mega backdoor Roth IRA).
What it is: a backdoor Roth IRA is a way to allow those who normally would have income above the normal Roth IRA contribution thresholds (for 2021, $140k for single filers and $208k for married filing jointly) to make a contribution.
Here’s how it works: you make a non-deductible IRA contribution to an IRA. When you do this, because you didn’t get a tax deduction, the contribution has basis. You then take these funds and convert the dollars into a Roth IRA. Roth IRA conversions are taxable to the extent that you have basis. So if you have $6,000 in basis, and then convert the full $6,000 into a Roth, it’s not taxable and voila! You have money in a Roth IRA.
If I haven’t lost you yet, hang on: there are a few caveats. If the IRA has grown at all prior to the conversion, you pay income tax on that growth. Also, you can’t have any other IRAs if you do this. The IRS lumps all IRAs together to see how much of your Roth conversion is taxable.
For example, let’s say you do the same steps as above but also have a $20,000 IRA. The IRS then will look at your $6,000 in basis, add that to your other $20,000 IRA bringing your IRA total to $26,000. It then takes the fraction of the basis to the IRA total (in our example, $6,000/$26,000 = 23%) and applies that percentage to your Roth conversion to find the taxable amount. In this case, 23% of the $6,000 contribution would be non-taxable and then remaining 77% would be subject to taxes.
You are also limited to the allowed IRA contribution for the year, which for 2021 is $6,000 (plus an additional $1,000 for those 50 and older). There’s a bigger version of this called the mega backdoor Roth IRA, which I won’t get into here because this is confusing enough, and not many people are eligible for this anyway (here’s a great article on them).
Why it matters: If this all sounds overly complicated to you, you aren’t wrong. But Roth IRAs are powerful. Let’s say we leave that original $6,000 in our Roth IRA and invested it in the stock market where it earned 6% each year. After 30 years, that Roth IRA would be worth $34,460 and wouldn’t be subject to any income taxes at withdrawal. That’s pretty amazing. Of course, the stock market goes up and down each year and it would depend on how you invested it, but more than likely it’s going to grow a lot over that time period. Chances are too that tax rates are going to keep going up. So is it worth jumping through hoops for that? Many financial planners think so.
What happens now: This new legislation would completely eliminate these types of conversions. Sad news. The bill still has to pass though, and it’s not clear this Congress will agree on much of anything. Stay tuned and keep an eye out for updates on our Facebook page or by signing up for our newsletter. If you’d like to see how a backdoor Roth contribution would fit into your financial picture, schedule a call.
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