Yahoo Movies Backdoor Roth IRAs: What Are They — and Will ‘Build Back Better’ Close Them?
A backdoor Roth IRA isn’t a specific type of IRA, rather a description of a strategy to help wealthier taxpayers avoid certain Roth IRA restrictions.
Backdoor Roth IRAs have been in the news as of late due to provisions in President Joe Biden’s “Build Back Better” legislation that would limit their use. Although the legislation is not finalized, it’s a good time for those who might be affected by it to take a look at their Roth IRA strategy and prepare to adapt to any potential changes.
Learn: What Is a Roth IRA?
Also See: How To Pick the Smartest Investment Strategy for Your Money
What Is a Backdoor Roth IRA?
As the name would suggest, a backdoor Roth IRA is a way to get money into a Roth IRA that wouldn’t normally be authorized. Since a Roth IRA provides great tax advantages in retirement, particularly for wealthy individuals, it’s perhaps not surprising that investors have exploited a loophole in the law that allows backdoor contributions.
Roth IRA Income Limits for Contributions
The backdoor Roth IRA exists only because Congress has put in place laws that prohibit wealthier individuals from contributing to them. Specifically, for tax year 2021, if you’re married and filing jointly and have a modified adjusted gross income (MAGI) greater than or equal to $214,000, you’re not allowed to make any contributions to a Roth IRA. Contributions phase out between incomes of $204,000 and $214,000, with full contributions allowed for incomes under $204,000.
That limit drops to $144,000 if you file as single, head of household or married filing separately and you did not live with your spouse at all during the year. The phase-out for these categories of filers ranges from $129,000 to $144,000.
If you did live with your spouse at any time during the year and are filing separately, the contribution limit drops all the way to $10,000, with incomes between $0 and $10,000 experiencing a phase-out.
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How Does a Backdoor Roth IRA Skirt Income Limits?
Currently, wealthier taxpayers can work around the Roth IRA income limits by instead making contributions to a traditional IRA. Since there are no income limits on contributions to a traditional IRA, higher-income taxpayers are free to contribute to an IRA up to the annual limit. Then, they can convert their traditional IRAs into Roth IRAs, thus providing the “backdoor” access to a Roth.
For example, let’s say you earn $300,000 in MAGI in tax year 2021. The IRS won’t allow you to contribute to a Roth IRA, but you can put up to $6,000 into a traditional IRA. Later, you can convert that $6,000 to a Roth IRA. This essentially makes the traditional IRA a funnel into your Roth IRA, allowing you to backdoor the Roth income contribution limit.
Taxpayers looking to maximize the amount they can convert to a backdoor Roth IRA could contribute to a 401(k) plan that allows Roth IRA conversions. As 401(k) plans have a higher annual contribution limit — $20,500 for tax year 2022 — it’s a quicker way to build up backdoor Roth IRA balances.
What Are the Ramifications of Using a Backdoor Roth IRA?
There are two main drawbacks to creating a backdoor Roth IRA. First, any pre-tax contributions you convert to a Roth IRA are fully taxable at the time of conversion. This applies to any earnings on these contributions as well. Second, you cannot access money converted to a Roth IRA for a full five years after the date of the conversion without facing a 10% early distribution penalty. However, many wealthier taxpayers find these small prices to pay in exchange for the lifelong tax-free benefits of a Roth IRA.
Of course, the way for taxpayers to avoid income tax on backdoor Roth conversions is to make after-tax contributions to a traditional IRA or 401(k) plan. Then, the only taxes due on conversion are on the earnings attached to those contributions.
Also See: 27 Best Strategies To Get the Most Out of Your 401(k)
What Provisions of ‘Build Back Better’ Will Affect Them?
President Joe Biden’s “Build Back Better” legislation was primarily focused on infrastructure, but it also included a few provisions that would ultimately eliminate the backdoor Roth IRA loophole.
Specifically, the legislation would prohibit any conversions of after-tax money from a traditional IRA or 401(k) plan to a Roth IRA. Second, it would prevent any conversion of pre-tax money from a traditional IRA or 401(k) to a Roth IRA for taxpayers with incomes in excess of $400,000 for single individuals, $425,000 for heads of household or $450,000 for joint filers.
Although the “Build Back Better” legislation passed the House of Representatives, it got caught up in the Senate and is currently being reworked. Although a new form of the bill is likely to make its way through Congress yet again, there’s no telling whether the provisions regarding the backdoor Roth IRA will be included.
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This article originally appeared on GOBankingRates.com: Backdoor Roth IRAs: What Are They — and Will ‘Build Back Better’ Close Them?
