Popular "Backdoor Roth" Technique May Be Ending Soon
When legal tax planning techniques become just a bit too popular and begin to cost the government big money (or they are needing to raise revenue to pay for something), they tend to become targets of Congress. Such is the case of an increasingly popular planning move that enables taxpayers who, due to income limitations, might otherwise not qualify to make a Roth IRA contribution to nevertheless do so.
This planning move that finds itself with a big old bullseye on its back is commonly known as a backdoor Roth, and the Build Back Better (or BBB) legislation currently working its way through Congress is clearly taking aim at it. In fact, if passed as currently written, the BBB act gives the backdoor Roth technique only a little over a week to live as of the date of this publication, since it effectively kills it beginning the first day of 2022.
For background, a taxpayer with earned income can contribute to a Roth IRA up to $6,000 (up to $7,000 if over age 50), but only if their modified adjusted gross income (MAGI) is under $125,000 for a single filer or $198,000 if married filing jointly. At those income levels, the amount allowed to be contributed begins to phase out, so that no contribution is allowed at MAGI of $140,000 for a single filer and $208,000 for a married couple filing jointly.
An important exception that allowed money to be added to a Roth IRA regardless of the income level was the ability to convert funds from a traditional IRA to a Roth IRA no matter the income level. Upon conversion, income taxes have to be paid on any IRA funds that were contributed on a pre-tax basis (i.e., had been deducted from taxable income) as well as any earnings in the account. After-tax contributions, however, can be converted with no taxes due, although earnings on such after-tax amounts are still taxable.
It was this conversion rule that gave rise to the so-called backdoor Roth contribution. You see, while deductible contributions to traditional IRAs are also limited by the same income rules stated above, it is possible to make a contribution to a traditional IRA on a nondeductible basis regardless of income.
The technique then, to get around the income limit rules for contributing to a Roth IRA, is to make a nondeductible contribution to a traditional IRA and then convert it to a Roth IRA. This is entirely legal and effectively is just like making the contribution to the Roth in the first place.
The icing on the cake is that as long as there are no other pre-tax contributions or earnings in your traditional IRA accounts, no taxes will be owed. This technique works so well, in fact, that I know many taxpayers who literally, on the first day of each year, make a nondeductible IRA contribution for that year, and then immediately convert it to their Roth IRA account. Because the funds aren't in the account long enough to earn any income, the process is completely tax-free.
You may be asking why people are motivated to do this in the first place. In other words, if you can make a nondeductible contribution to a traditional IRA, why not just do that and be done with it, since you don't get a tax deduction for a Roth IRA contribution either?
The answer lies in the tax benefits associated with a Roth that you don't get with a regular IRA. Specifically, if held the requisite five years in a Roth, the earnings that build up inside the Roth will NEVER be taxed, unlike the traditional IRA in which the earnings will be taxed.
Further, with a traditional IRA, at age 72 you are required to begin taking "required minimum distributions", or RMDs. You have no choice in the matter and income tax will have to be paid on some, if not all, the amount. The Roth IRA is not subject to the RMD rule, so the owner can take smaller distributions, and in fact, never has to take a distribution at all if they don't want to, allowing the account to grow even more tax-free.
The backdoor Roth maneuver has helped many many taxpayers to be able to build their Roth IRA accounts and avail themselves of the above tax benefits who otherwise wouldn't have been able to do so. There appears to be a very strong likelihood, however, that this planning move is on life support and could end with the New Year's Eve ball drop.
If this applies to you and you haven't already made your 2021 contribution and conversion, you should consider taking steps now to meet what appears could be a December 31 last chance to do so.
Lane Keeter, CPA, is Office Managing Partner of the Heber Springs office of EGP, PLLC, CPAs & Consultants (a full-service financial firm with offices in Heber Springs, North Little Rock and Bryant) and past winner of The Sun-Times Reader's Choice Award for Best Accountant