Slamming the back door
Congress is getting ready to slam the door on a popular retirement savings strategy—the so-called back-door Roth conversion. This is regrettable from a financial planning perspective because back-door Roth conversions are a simple and effective way to boost retirement savings.
Several years ago, Congress placed income limits on Roth IRA contributions. Under current law, single taxpayers lose their ability to contribute to Roth IRAs if their annual taxable income is above $140,000 and married-filing-jointly taxpayers are locked out at income levels above $208,000.
However, there is a back door. Anyone, regardless of income, can make an after-tax contribution to a traditional IRA, and anyone can convert their traditional IRA to a Roth. Once you understand these facts, using the back door is a simple two-step process.
Step 1: Make an after-tax contribution to your traditional IRA.
Step 2: Convert the after-tax contribution to a Roth.
Because the contribution was made with after-tax dollars, you owe no tax on the conversion and the end result is no different than if you went in through the front door. Who knew the back door could be so elegant?
Despite its elegance, the back-door Roth was always somewhat controversial. Though not explicitly called out, the back door was a subtle, though intentional feature of the 2005 Tax Increase Prevention and Reconciliation Act. Without going into all the nitty-gritty details, let’s just say it was part of a legislative package designed to allow the bill to pass the Senate with a simple majority vote instead of triggering a provision that would have required 60 votes. The Republicans, at the time, had 55 Senate seats. Given the politics, I’m sure you can see why some members of Congress never liked the back-door Roth conversion and why they have been gunning for it ever since.
For many years, people feared that the IRS would disallow back-door Roth conversions using what is called the step transaction doctrine. The step transaction doctrine says that if the end result of multiple legal steps is illegal, then the steps leading up to it are illegal also. In other words, if people above a certain income level are prohibited from going through the front door, then they are also prohibited from going through the back door. However, in 2018 the IRS issued a statement saying they did not view back-door Roth conversions as step transactions. Since then, the use of back-door Roth conversions has boomed. In fact, in keeping with the maxim “if a little is good, a lot must be better”, back-door conversions have morphed to include something called the “mega back-door Roth conversion.”
A mega back-door Roth conversion follows the same pattern we just described, but it starts with a traditional 401(k) plan instead of a traditional IRA. The “mega” in its name comes from the higher contribution limits for 401(k) plans. A traditional IRA only allows annual contributions of $6,000 plus another $1,000 if you are over 50 years old. A 401(k) plan, in contrast, allows you to put as much as $38,500 into a Roth account on top of your regular contribution. Once you make your after-tax contribution to your traditional 401(k) plan, the plan administrator automatically converts it to a Roth IRA or a Roth 401(k) account. Once again, since it is after-tax money, you pay no tax on the conversion.
Not all 401(k) plans can do a mega-back-door Roth and not all should. In order to do a mega-Roth conversion, your 401(k) plan would need to permit after-tax contributions above and beyond the normal employee deferrals. Plans that permit after-tax contributions are required to perform an annual anti-discrimination test to make sure the plan is fair to non-highly compensated employees relative to highly-compensated employees. If a plan is deemed to favor highly-compensated employees, it is required to refund all contributions made by highly-compensated employees.
If you are at all interested in doing a back-door Roth conversion, you will need to act quickly. The House Ways & Means Committee just approved an amendment that would eliminate this opportunity as of January 1, 2022, so this door may soon close for good. Check with your advisor or retirement plan administrator.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have about investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to firstname.lastname@example.org.