Is the back door of the Roth IRA disappearing before our eyes? | Smart Change: Personal Finance

(Sam Swenson, CFA, CPA)

The grumbling from Washington has savvy retirement savers a bit worried: Will this year be the last to benefit from a smart tailgate? Ruth Iran strategy? Let’s look at Roth’s current legal setup and how it could change in 2022.

The Backdoor Roth IRA today

A Roth IRA is one of the few tax-exempt vehicles designed to boost retirement for low and middle income earners. You can contribute up to $6,000 directly to Roth accounts in 2021 ($7,000 if you are over 50), to eventually use in retirement after you turn 59-and-a-half. The beauty of a Roth IRA is that once you contribute money and invest it, you never pay tax on it again – neither when you receive a dividend, nor when you withdraw the money, as long as you meet the qualifications.

But Roth IRA comes with income limits. You cannot earn more than $206,000 in 2021 and still contribute directly to a Roth IRA. As a result, high-income earners are prohibited from contributing to a Roth and thus excluded from enjoying full tax exemption as a retirement savings method.

This is where the back door strategy comes in. The income limits described above only apply to Roth IRAs – anyone can contribute to traditional ira. For years, some smart people contributed after-tax money (like the money you receive in your bank account when you pay) to traditional IRAs and then around to Roth mode. If they set things up correctly, the transfer will not result in any tax.

Functionally, this is a way for people – especially those with high incomes – to contribute money to a Roth IRA without contributing directly for one. It’s a valuable alternative solution for people who will be taxed on investment gains and capital gains if the money is to be held in a taxable brokerage account.

While $6,000 a year doesn’t seem like a lot, an annual Roth IRA can lead to large account balances in the long run. If someone had to do this over 30 years (assuming an 8% annual return), they would have more than $680,000 to spend in retirement, completely tax-free.

Image source: Getty Images.

Close the back door

Suggested Legislation – Proposing the means and methods of the House of Representatives to the Democrats, to be exact – states that after-tax funds are no longer eligible for transfer to Roth IRAs. The big idea? The backdoor Roth IRA vulnerability will be closed at long last.

This change will also apply to “massive” background Roth transfers, which include the contribution of after-tax funds to workplace plans, such as 401(k) s. Not all 401(k)s allow huge after-tax contributions to their plans, but in those that do, the opportunity to convert that money into Roth status will be missed.

What does this mean for you

Losing the back door to a Roth IRA isn’t inconsequential for tax-sensitive high-income individuals, and will certainly force retired savers to look elsewhere to cover the cost of their senior years.

A good first step for those who are concerned about the end of a Roth IRA tailgate is to make sure it is completed for the 2021 calendar year. In other words, you may only have a few months left to contribute to a traditional IRA and then Transfer money to Roth. If you can swing it, contributing the entire $6000 and transferring it to Roth before the year up is a wise planning move.

Then, you might look to make the most of the rest of your tax-deferred space, such as in 401(k)s and 403(b)s. Make sure you are contributing enough to benefit from any employer match or profit sharing contributions, which are specific to the employer. If you are self-employed or do any independent work, a Solo 401(k) may also be an option for you.

Not legal yet, but be prepared

There is no guarantee that the Roth IRA tailgate is gone, but there are some indications that it may be. Take action now to secure your backdoor Roth IRA contribution for 2021, then wait to see how the law applies in 2022.

We’ve seen legislation delayed before and certainly wouldn’t be surprised if it’s delayed again. But all you can do from a financial planning perspective is follow the rules as they are today and hope the door stays open for a while longer.

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