Slam the back door – Monterey Herald
Congress is about to slam the door on a popular retirement savings strategy – the so-called Roth backdoor conversion. This is unfortunate from a financial planning standpoint because backdoor Roth conversions are a simple and effective way to increase retirement savings.
Several years ago, Congress imposed 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 greater than $ 140,000 and jointly reporting married taxpayers are stranded at income levels greater than $ 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 backdoor 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 result is no different than if you had walked in through the front door. Who knew the back door could be so elegant?
Despite its elegance, the Roth backdoor has always been somewhat controversial. Although not explicitly invoked, the backdoor was a subtle, albeit intentional, feature of the Prevention and Reconciliation of Tax Hikes Act 2005. Without going into all the details, let’s just say that this was part of a legislative package designed to allow the bill to pass through the Senate with a simple majority vote instead of triggering a provision that would have required 60 votes. . Republicans at the time had 55 seats in the Senate. Given the politics, I’m sure you can see why some members of Congress never liked Roth’s backdoor conversion, and why they’ve been suing him ever since.
For many years, people feared that the IRS would ban Roth conversions through the backdoor using what is known as the Staged Transaction Doctrine. The staged transaction doctrine says that if the outcome of more than one legal step is illegal, then the steps leading up to it are also illegal. In other words, while people above a certain income level are prohibited from going through the front door, they are also prohibited from going through the back door. However, in 2018, the IRS issued a statement that it did not view Roth backdoor conversions as staged transactions. Since then, the use of Roth backdoor conversions has exploded. In fact, in keeping with the maxim “if a little is good, a lot must be better,” backdoor conversions have morphed to include what’s called the “Roth mega backdoor conversion.”
A backdoor Roth mega-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 an additional $ 1,000 if you are over 50. A 401 (k) plan, on the other hand, allows you to put up to $ 38,500 in a Roth account in addition to your regular membership fee. Once you’ve made your after-tax contribution to your traditional 401 (k) plan, the plan administrator automatically converts it to a Roth IRA or Roth 401 (k) account. Again, since this is after-tax money, you pay no tax on the conversion.
Not all 401 (k) plans can do a Roth mega backdoor, and not all should. To perform a mega-Roth conversion, your 401 (k) plan should allow after-tax contributions beyond the normal employee deferrals. Plans that allow after-tax contributions are required to conduct an annual non-discrimination test to ensure that the plan is fair for non-highly paid employees versus high-paid employees. If a plan is deemed to favor high-paid employees, it is required to refund all contributions made by high-paid employees.
If you’re interested in a Roth backdoor conversion, you’ll need to act quickly. The House Ways & Means Committee has just approved an amendment that would eliminate this opportunity as of January 1, so that door may soon close permanently. Ask your advisor or pension plan administrator for more information.
Steven C. Merrell is a partner at Monterey Private Wealth Inc., an independent wealth management firm in Monterey. He accepts any questions you may have regarding investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to [email protected]