- Backdoor Roth IRA Contributions can save you money and are still legal
- Build Back Better may change this, so it’s important to act soon
- 2022 may be a year of changes, so be sure to follow us
Starting in 2021, the Backdoor Roth IRA has allowed all income earners the ability to make a Roth IRA contribution. Prior to 2010, any taxpayer that had income above $100,000 was not allowed to do a Roth IRA conversion which prevented one from making an after-tax IRA contribution and converting to a Roth. The 2009 financial crisis caused a change in law as the Treasury was in desperate need of tax revenue and Roth conversions are a simple way of accelerating tax payments. Hence, in 2010 the Backdoor Roth IRA was born.
For high income individuals, contributing funds to a Roth IRA is only possible through a solution known as the “Backdoor” Roth IRA. In 2022, the maximum Roth IRA contribution limit was $6,000, or $7,000 if at least age 50. This is because the IRA rules impose income limitations on Roth contributions but no longer include income limitations on Roth IRA conversions.
In general, in 2022, if one is single and earns more than $144,000 or is married and files jointly and earns more than $214,000, one is not permitted to make Roth IRA contributions. However, under the “Backdoor” Roth IRA strategy, one who earns more than the Roth IRA income limitations (i.e., $214,000 in 2022 and married and filing jointly), can make an after-tax IRA contribution and then immediately convert the funds to Roth.
How Does The Backdoor Roth IRA Work?
After-tax contributions are traditional IRA contributions that are not tax-deductible. The income and gains on traditional after-tax contributions are subject to tax. Thus, making Traditional after-tax contributions other than for purpose of a “Backdoor” Roth IRA contributions does not make much sense. In essence, it is the worst option since an after-tax contribution is not tax deductible and the income and earnings are subject to tax, as well as a 10% early distribution penalty, if applicable.
Below is an example how the Backdoor Roth IRA solution works:
Pam is married, and she and her husband have income over $214,000. Pam could not make a Roth IRA contribution because her income is too high. Thus, Pam can make a traditional IRA contribution and not take a tax deduction (after-tax contribution) and can then immediately convert the after-tax funds to Roth. There would be no tax on the conversion from after-tax to Roth, although, if Pam had other pretax IRAs at the time of the conversion, the amount converted to Roth could be limited based on a pro rata conversion requirement.
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Assume further Pam wished to make a Backdoor Roth IRA contribution of $5000 in 2022 but had a Traditional IRA worth $5,000 she started in 2015. Under the pro rata conversion rule, only 50% of the $5000 Backdoor Roth IRA contribution from 2022 would be deemed Roth. The pro rata backdoor Roth IRA rules work as follows if you have Traditional IRA contributions from past years: (i) add all Traditional IRA contributions and (ii) divide by amount of current year after-tax IRA contribution. Then take that percentage and multiply against current year backdoor IRA contribution. That amount will be deemed converted to Roth from the after-tax contribution amount.
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Roth IRA Advantage
The major advantage of having a Roth IRA is that all income and gains can be distributed tax-free if you are over the age of 59 1/2 and the Roth IRA has been opened at least 5 years. In other words, the Roth IRA distribution would not be subject to any income tax or capital gains so long as the Roth IRA holder is over the age of 59 1/2 and the Roth has been opened at least five years. In addition, Roth IRAs are not subject to any required minimum distributions.
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Build Back Better & Backdoor Roth IRA
In November 2021, the House narrowly passed the Build Back Better (“BBB”) bill, the centerpiece of President Biden’s domestic agenda on Friday, approving $2.2 trillion in spending over the next decade to battle climate change, expand health care and reweave the nation’s social safety net, over the unanimous opposition of Republicans. However, as a result of Sen. Joe Manchin, D-W.Va opposition, the Bill was not able to pass the Senate as is currently dormant. The Bill contains a number of retirement related provisions, including a provision that would eliminate the conversion of after-tax contributions to Roth for 2022 and beyond, thereby, killing the Backdoor Roth IRA solution.
So the question is, will the BBB be passed in 2022 and will the bill eliminate the Backdoor Roth IRA for 2022 and beyond? No one really knows, but there is a good chance some revised form of the BBB will pass the Senate in 2022. Accordingly, there is a strong chance the BBB will include a provision eliminating the Backdoor Roth IRA. Although, it is unclear if the provision would apply to 2022 or be pushed back a year until 2023. The belief is that if the BBB does not get passed before March 2022, there is a solid chance the Bill will allow for Backdoor Roth IRA conversions in 2022 but eliminate them for 2023 and beyond.
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As of March 2022, the Backdoor Roth IRA is still alive. Therefore, any taxpayer making more than $214,000 in income and is married and filing jointly can make an after-tax Traditional IRA contribution and then potentially do a tax-free Roth IRA conversion. However, depending on if and when the BBB bill gets passed, and whether the backdoor elimination provision remains in the bill, 2022 may be the last year for the Backdoor Roth IRA solution. While we cannot predict the future, IRA Financial can still help you complete the Backdoor Roth today!