Among the many provisions in the multi-trillion-dollar legislative package being debated in Congress is a provision that would eliminate a strategy that allows high-income investors to pursue tax-free retirement income: the so-called back-door Roth IRA. The next few months may present the last chance to take advantage of this opportunity.
Roth IRA
Since its introduction in 1997, the Roth IRA has become an attractive investment vehicle due to the potential to build a sizable, tax-free nest egg. Although contributions to a Roth IRA are not tax deductible, any earnings in the account grow tax-free as long as future distributions are qualified. A qualified distribution is one made after the Roth account has been held for five years and after the account holder reaches age 59½, becomes disabled, dies, or uses the funds for the purchase of a first home ($10,000 lifetime limit).
Unlike other retirement savings accounts, original owners of Roth IRAs are not subject to required minimum distributions at age 72 — another potentially tax-beneficial perk that makes Roth IRAs appealing in estate planning strategies. (Beneficiaries are subject to distribution rules.)
However, as initially passed, the 1997 legislation rendered it impossible for high-income taxpayers to enjoy Roth IRAs. Individuals and married taxpayers whose income exceeded certain thresholds could neither contribute to a Roth IRA nor convert traditional IRA assets to a Roth IRA.
A Loophole Emerges
Nearly 10 years after the Roth’s introduction, the Tax Increase Prevention and Reconciliation Act of 2005 ushered in a change that relaxed the conversion rules beginning in 2010; that is, as of that year, the income limits for a Roth conversion were eliminated, which meant that anyone could convert traditional IRA assets to a Roth IRA. (Of course, a conversion results in a tax obligation on deductible contributions and earnings that have previously accrued in the traditional IRA.)
One perhaps unintended consequence of this change was the emergence of a new strategy that has been utilized ever since: High-income individuals could make full, annual, nondeductible contributions to a traditional IRA and convert those contribution dollars to a Roth. If the account holders had no other IRAs (see note below) and the conversion was executed quickly enough so that no earnings were able to accrue, the transaction could potentially be a tax-free way for otherwise ineligible taxpayers to fund a Roth IRA. This move became known as the back-door Roth IRA.
(Note: When calculating a tax obligation on a Roth conversion, investors have to aggregate all of their IRAs, including SEP and SIMPLE IRAs, before determining the amount. For example, say an investor has $100,000 in several different traditional IRAs, 80% of which is attributed to deductible contributions and earnings. If that investor chose to convert any traditional IRA assets — even recent after-tax contributions — to a Roth IRA, 80% of the converted funds would be taxable. This is known as the “pro-rata rule.”)
Backdoor Roth Strategy
If you earn too much, you’re barred from contributing to a Roth IRA unless you can use the backdoor Roth technique. The backdoor Roth strategy involves making a nondeductible contribution to a traditional IRA and then rolling that money into a Roth.
In order for the strategy to work most successfully, you cannot have traditional IRA account balances. A non-deductible traditional IRA contribution converted to a Roth IRA can result in taxable income if you have an account balance in a traditional IRA, including a 401(k) rolled over into an IRA.
Keep in mind that with some planning, you can avoid any taxes on the rollover. For example, if you have an existing traditional IRA, you can move those monies to a qualified plan to avoid having the backdoor strategy trigger some taxes. And if you have no traditional IRA, the nondeductible contribution to the traditional IRA and the subsequent rollover to the Roth IRA triggers no taxes.
Mega Backdoor Roth Strategy
The mega backdoor Roth strategy applies the same concept as the backdoor Roth IRA, but involves your 401(k) plan at work. With a mega backdoor Roth, you make up to $40,500 in non-deductible contributions to an eligible 401(k) plan. This strategy is complicated and may not be available for all company plans but is worth exploring if you are aiming to maximize your Roth retirement assets.
Roth 401(k)
Another funding strategy for Roth is to contribute to your employer’s Roth 401(k). By making a contribution to a Roth 401(k), you get the same benefits of your after-tax contribution being tax-free when withdrawn at retirement, but your contribution is not limited based on your income. If you leave an employer and want to rollover your Roth 401(k), you can do so into a Roth IRA.
If you have questions about how this topic will impact you, Team LittleOwl CPA is here to help. Schedule a discovery call today!
About Tabitha Regan
Tabitha Regan is the Founder and CEO of LittleOwl CPA. Tabitha is a Certified Public Accountant, Certified Financial Planner™ and Personal Financial Specialist. In her 16+ year career span, she has developed an expertise in the specific needs of small businesses and busy professionals with accounting, tax and advisory services.
