In this episode of Adam Talks, IRA Financial’s Adam Bergman Esq. discusses the Backdoor Roth IRA, a solution for high income Americans to get funds into the tax-advantaged account, and whether or not it is still a legal strategy in 2022.
Is the Backdoor Roth IRA Still Legal in 2022?
Hey, everyone, Adam Bergman here, tax attorney and founder of IRA Financial. On today’s Adam Talks, going to be chatting about is the Backdoor Roth IRA still legal? Well, the short answer is yes, thankfully. The reason I want to do this podcast is because I’ve recently gotten a lot of questions; maybe it relates to the new Biden-led legislation, the IRA, that’s climate, inflation gearing, legislation that’s in the Senate that will likely pass and go back to the House and ultimately become law and reminded people the Build Back Better (BBB) Act that was promoted back in September 2021 and included some really nasty retirement provisions, including a ban on the Backdoor Roth IRA.
Now, thankfully, Build Back Better bill died, never actually was alive, so it just never made it to life, thankfully. We worked really hard, I did a lot of podcasts and videos and blogs about it, and so did everyone in the self-directed industry, and so did a lot of our clients. So, it was kind of a joint effort that we were able to curtail that piece of legislation. Thanks also to Manchin and Sinema, who made sure that the retirement-related provisions were not part of any larger bill.
So, where we are today, August 2022, is you can still do Backdoor Roth IRAs. Just to be crystal clear – what’s a Backdoor Roth IRA? It means that no matter what your income level is, whether it’s $50,000, $50 million, $200 grand, $800 grand, you can make Roth IRA contributions. Now, without the Backdoor Roth IRA, prior to 2010, if you made above a certain income threshold, which is now approximately $214,000, you technically cannot do a Roth IRA. Okay, so what do you do? Well, there’s something called the Backdoor Roth IRA, which, beginning after 2010, there’s no longer any income limitations on conversions. Prior to 2010, if you made above $100,000, you cannot do a Roth conversion. But 2010, what happened? We all remember 2008-2009 economic crisis and what happened? Treasury needed money. They need money, what’s an easy way to capture tax revenue is to trigger taxable events, i.e. conversions. When you do a conversion of pretax retirement funds to Roth, you pay tax at ordinary income levels on what you convert. Now, you may be saying, well, yeah, that’s good for the government now, but in 20 or 30 years, when everyone has Roth IRAs, that’s not going to be really good because no one’s going to pay tax on that income.
The benefit of the Roth IRA, so long as you’re over 59 and a half and the Roth’s been open at least five years, it’s tax free when you pull the money out, it’s a qualified distribution. So, you may be thinking, well, that’s not really good down the road, at least for Treasury, who needs tax revenue to build roads and pay for our military and do all the great stuff that makes America the greatest country in the world. The truth is our politicians don’t really care what happens in 20 or 30 years. Maybe they care, but not as much as they care what happens in the next four to eight years when they’re actually in office. They have to get reelected. So, they’re just kicking that can down the road for someone else to deal with.
So, the Backdoor Roth IRA is a great way for Roth lovers who want to put away $6,000 or $7,000 if they’re over 50 and make too much money, right? Remember I said, if you make more than $214,000 in 2022, you can’t do a Roth IRA. But since there’s no income limitations on conversions, you can do a Backdoor Roth IRA. Which means, step one, you open a traditional IRA, you make an after-tax contribution; so you don’t get a tax deduction for that $6,000 or $7,000. And then you immediately convert it to Roth, since it’s after tax to Roth and not pretax to Roth, there’s no tax on the conversion. If you put $6,000 into an account today and then convert it tomorrow from after-tax to Roth, that $6,000 didn’t earn any investment income, right? You didn’t earn interest, didn’t buy anything; so there’s no potential gains. So that’s why there’s no tax on that conversion.
Now, a couple of things to remember. If you have other pretax IRAs out there, remember this. So, let’s say you have an IRA back in 2012 and 2016 – it’s worth $6,000. And now you want to do a $6,000 Backdoor Roth IRA contribution in 2022 and you have enough income, you made more than $214,000, let’s say, so you can’t do a Roth in itself. So you do an after-tax IRA contribution and then you immediately convert it to Roth, as I mentioned just a minute ago. However, the rule suggests that if you have other IRA, pretax IRA, not Roth, but if you have other pretax IRA contributions out there, you can’t convert all of it from the Backdoor to Roth. It’s a pro rata percentage. So, based off this example, you have six of pretax IRAs that accumulated over the years. Now you want to do a $6,000 Backdoor, so that’s six and six – six divided by 12 – 50 percent. That means $6,000 of the after-tax Roth, that backdoor, only half of it could be transferred to Roth. The rest of the $3,000 will stay in after-tax, and you’ll have to eventually convert that to Roth. Okay, so that pro rata formula only applies if you have preexisting IRAs out there. A lot of people don’t realize that rule exists, and they assume that they’re just going to be able to automatically Backdoor Roth whatever they put in into the backdoor this year. If you have preexisting, pretax IRA accounts, it’s not that simple; you have to take a pro rata formula.
So, a couple of things to remember here, Backdoor Roths. I do them; I just love having Roths, even if it’s $6,000, it adds up, right? If you keep doing them for the next 20-30 years, assuming the law stays intact, you’re going to have a lot of money accumulate tax free. Roth IRAs are super powerful for patient investors. If you are not patient, you don’t think you’re going to be able to resist taking money out of the Roth IRA before you’re 59 and a half, before the Roth’s been open at least five years, don’t do Roths because you’re just going to lose any of the potential benefits by paying tax and a 10% penalty on any earnings. Okay? So just remember that: 59 and a half and five years.
Backdoor Roth IRAs have been done since 2010. Again, the Build Back Better bill that never saw the day of light, thankfully, had a provision in there to eliminate it. That never became law. The recent legislation, the IRA provision and the word IRA, it’s not an IRA legislation, that’s just what it’s called. That seems like it’s going to pass the Senate shortly. Sinema just recently said that she would support it so long as they got rid of the carried interest legislation that sought to move the three year holding period to five years. So, it seems like this is going to go, but again, there’s no IRA provision in there, even though it’s called the Inflation Reduction Act. It’s called IRA; it has nothing to do with retirement account.
So, I wanted to do this podcast because I’ve got, in the last week or so, a bunch of questions on the Backdoor, and I kept asking, why are people asking about the Backdoor Roth, whether you can do it in 2022? Because, we know, pretty much towards the end of 2021, when the Build Back Better bill basically died, we were comfortable and we made it super clear I did, at least, in videos and blogs and podcasts and our industry as well, that the Backdoor Roth IRA is still good to go. It’s vibrant and legal. But, with this new legislation, I guess people start thinking, hey, maybe those IRA provisions are in there. Also, the name of the bill is IRA, Inflation Reduction Act, which I think got people spooked and saying, oh crap, maybe there’s IRA provisions in there, maybe it is an IRA-type bill.
So, just to be crystal clear, super super clear, the Backdoor Roth IRA is still legal in 2022, this Inflation Reduction Act has nothing to do with IRAs or retirement accounts. If you make more than $214,000 in 2022, you’re married filing jointly, you cannot do a Roth IRA, but you can still do a Backdoor Roth IRA, which allows you $6,000, or $7,000 if you’re over 50, go after-tax and then immediately convert to Roth. Only thing to remember is that if you have other preexisting pretax IRA accounts out there, you’re going to have to do some type of pro rata formula to determine how much of the Backdoor Roth IRA for 2022 will actually become Roth. Remember, still 59 and a half and five year rule to pull out all the Roth IRA earnings tax free, which is obviously the pot of gold we’re all waiting for; is hopefully we’re going to make some good investments. Be patient. That money is going to keep growing and it’s all going to be tax-free at the end of the day, which is what we are all building for.
So that’s it. Wanted to keep this podcast short and sweet because there’s really not a lot of controversy. Backdoor Roth IRAs are legal. They hopefully will be legal for many years. I plan on taking advantage of it. So should you, if you can. If you make less than 214, you’re married to all jointly, then go Roth. There’s no reason, even if you put $500, $1,000, $2,000, go Roth okay? I’m just a big supporter of the Roth. Yes, you do not get a tax deduction today, but again, if you’re patient and you’re willing to wait until your 59 and a half, the Roth has been open at least five years; Bang! Everything you pull out is tax free. Any distribution will be tax-free, which I think is pretty, pretty cool and definitely worth the patience.
So, thank you for listening. If you are watching on YouTube, thank you. You can always subscribe to the IRA Financial channel, which is, I think, a great channel; I think it’s the best content out there for self-directed retirement subject matters. Personally, as a tax lawyer, I take great pride in the content, so I hope you guys enjoy it. If you have any comments or questions, you can email us at [email protected] and we will do our best to get to it.
Otherwise, I hope you guys are enjoying your summer and you’re staying cool. Weather is a bit wacky out there, no matter where you live, whether that’s heat waves or flooding or forest fires. So, stay safe and I’ll talk to you again next week. Take care.