Roths as a Retirement Strategy: Locking the Backdoor?
Roth conversions have become an essential part of the retirement toolkit. They allow investors with retirement savings in a Traditional plan to pay the taxes they deferred when they contributed and then have tax-free growth and more flexibility in income planning throughout retirement. Unlike investing in a Roth directly, there are currently no income limits.
A new proposal before Congress would impose new income limits on Roth conversions and would also make other changes that may curtail retirement planning flexibility. While it’s unclear if these will become law, if you’ve been thinking of a Roth conversion – time may be of the essence.
Let’s Back Up: What’s a Roth Conversion and Why is it Important?
Roth IRAs and 401(k)s were created for savers who believe they will be in a lower tax bracket now than in retirement. These savers are usually not in the later stages of their careers or have lower income levels. The maximum income limit for opening a Roth is $140,000 in 2021. Contributions are not tax-deferred, as in Traditional retirement accounts. The taxes are paid on the funds before they are put in the Roth account. Because taxes are paid upfront, no taxes are due on withdrawal, and there are no required minimum distributions (RMDs), as there are with traditional accounts.
For retirees with Traditional retirement accounts, converting to a Roth means taking the tax hit when the funds are withdrawn. This is usually spread over several years and is timed for years when income will be lower. Once the taxes are paid, and the conversion is complete, the retiree can enjoy tax-free growth of the account. With taxes likely to rise in the future, a Roth conversion is a way to lock in today’s tax rates. And because there are no RMDs, the account has potential to maximize growth.
It also creates flexibility in income planning. In retirement, it’s important to keep income from all sources at a level that won’t trigger excess taxes on Social Security benefits (up to 85% of which are taxable) and that won’t be high enough to result in a Medicare Part B surcharge.
Finally, there are no restrictions for passing on a Roth account. The account is tax-free and can be passed on as part of an estate, without the heirs having to withdraw all assets within ten years, as is the case with a traditional account.
What’s the Backdoor Roth?
The Backdoor Roth IRA is an additional strategy that follows the Roth conversion playbook. Currently, to generate additional retirement savings, an investor can open a Traditional IRA, invest the maximum allowed ($6,000 in 2021) in after-tax dollars, and then convert to a Roth. Because it is a conversion, it doesn’t matter how much money the investor currently makes, as there are no income limits. So even a high-earning saver can use the strategy to lock in current tax rates and create tax-free growth of investment dollars.
The Mega Backdoor Roth applies to an employer-sponsored 401(k) plan that allows non-Roth employees after-tax contributions. Since 401(k)s allow up to $58,000 in total contributions (employee, employer and additional after-tax), you can contribute more than your own tax-deferred funds and your employer’s matching funds, up to $58,000. These additional after-tax funds can either be converted directly into a Roth IRA, or some plans require that you wait until retirement.
What is in the Proposal?
The proposed changes are part of restructuring the tax code as part of the $3.5 trillion Build Back Better budget plan. The plan contains further infrastructure spending, addresses climate change, and seeks to bolster the social safety net. Paying for it is the problem – and that’s what is leading to these proposals.
Overall, the plan seeks to raise taxes on individuals making more than $400,000 per year. This translates to retirement accounts as an effective repeal of the Roth IRA and 401(k) conversion for those whose income is over the $400,000 threshold ($450,000 per year for couples). Under the current proposal, there would be a ten-year phase out until December 31, 2031.
The Backdoor Roth and the Mega Backdoor Roth, however, would be eliminated this year. The bill would prohibit all after-tax contributions to company retirement plans and to traditional IRAs from being converted to a Roth IRA regardless of income level.
The Bottom Line
It’s impossible to know what the final bill will look like and if it will pass. But if maximum flexibility in your retirement planning is your goal, sneaking in the backdoor sooner rather than later might be a good idea.
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