The Backdoor Roth IRA lives! The proposal to repeal the Backdoor Roth IRA as of January 1, 2022 will not be enacted in 2021, as it is now abundantly clear that the Build Back Better legislative program will not be enacted anytime soon.
But could the proposal come back in 2022? How does one do financial planning in this regard in this climate of uncertainty?
Below I discuss how I approach the issue of whether one should execute a Backdoor Roth IRA in early 2022. What follows is my opinion of the possibilities that could play out. They are simply one person’s opinion in the face of a somewhat uncertain situation.
Nothing below is tax advice for any individual taxpayer to rely upon.
Planning for Uncertainty
To tackle the issue of whether to execute a Backdoor Roth IRA in early 2022, I believe it is best to think of a hypothetical example and then consider all of the (currently known) possibilities in terms of law changes and their probabilities of occuring. So here’s a hypothetical example:
Single Nurse is 35 years old, single, and makes $170,000 at her W-2 job in 2022. She is covered by a 401(k) at work. Her 2022 modified adjusted gross income (“MAGI”) makes her ineligible to make an annual contribution to a Roth IRA. On January 1, 2022, Single Nurse contributes $6,000 to a traditional IRA. On January 5, 2022, Single Nurse converts the entire balance in her traditional IRA, $6,000.23, to a Roth IRA. Assuming Single Nurse takes no other action, she will have $0 in all traditional IRAs, SEP IRAs, and SIMPLE IRAs on December 31, 2022.
Will Single Nurse be happy she executed a Backdoor Roth IRA early in 2022?
Let’s analyze the various possibilities in terms of new laws during 2022 and how they could impact Single Nurse’s 2022 Backdoor Roth IRA. Many thanks to Pixabay.com for the emoji reaction pictures and the featured image!
Note that Possible Outcomes #3 through #6 include the small possibility that Congress enacts a repeal of the Backdoor Roth IRA separate from the Build Back Better program.
Possible Outcome #1: No Portion of Build Back Better is Enacted in 2022
Sean’s Estimated Probability of Occurring: 70%
Under this outcome, Single Nurse is quite pleased with her 2022 Backdoor Roth IRA. She’s happy she executed it, even though she could have done it much later in the year.
Single Nurse’s reaction:
Possible Outcome #2: A New Version of Build Back Better is Enacted in 2022 Which Does Not Repeal the Backdoor Roth IRA
Sean’s Estimated Probability: 15%
Single Nurse is again quite pleased with her 2022 Backdoor Roth IRA in January, even though she could have waited.
Single Nurse’s reaction:
Possible Outcome #3: A New Version of Build Back Better is Enacted in 2022 Which Repeals the Backdoor Roth IRA Effective January 1, 2023
Sean’s Estimated Probability: 10%
Single Nurse is again quite pleased with her 2022 Backdoor Roth IRA in January, though she’ll miss the Backdoor Roth IRA in 2023.
If Congress does enact legislation in 2022 to repeal the Backdoor Roth IRA, I agree with Steven Rosenthal that the most likely effective date is January 1, 2023, which would be the easiest to implement. Changing tax laws during a year creates needless complexity and confusion, and thus I believe a January 1, 2023 effective date is the most likely effective date.
Single Nurse’s reaction:
Possible Outcome #4: A New Version of Build Back Better is Enacted in 2022 Which Repeals the Backdoor Roth IRA Effective On the Date of Enactment
Sean’s Estimated Probability: 3%
Single Nurse breathes a huge sigh of relief! If she had waited until later in 2022 to execute her 2022 Backdoor Roth IRA, she would not have been able to. She got her 2022 Backdoor Roth IRA in under the wire, and is very happy she executed the Backdoor Roth IRA early in January.
Single Nurse’s reaction:
Possible Outcome #5: A New Version of Build Back Better is Enacted in 2022 Which Repeals the Backdoor Roth IRA Effective January 1, 2022 and the IRS Treats an Early 2022 Backdoor Roth IRA as a Correctable Excess Contribution to a Roth IRA
Sean’s Estimated Probability: 1.6%
This is where it gets really interesting. First of all, a law retroactively repealing a tax law benefit would likely face some sort of legal challenge were to be enforced retroactively. For now, I will put an analysis of that outcome to the side.
How would the IRS enforce a repeal of the Backdoor Roth IRA as applied to Backdoor Roth IRAs executed prior to the law change but after a January 1, 2022 effective date? Single Nurse’s Backdoor Roth IRA is both post-effective date and prior to the enactment of the law change.
This situation would require an administrative transition rule from the IRS and Treasury. I believe the only feasible transition rule would be for the IRS to treat any pre-enactment/post-effective date 2022 Backdoor Roth IRA as an excess contribution to a Roth IRA. Under the excess contribution rules, excess contributions are generally correctable.
This treatment would give Single Nurse three potential courses of action:
- Withdraw the $6,000 and the growth on the $6,000 from the Roth IRA (a corrective distribution) by October 16, 2023.* Any growth on the $6,000 originally contributed is taxable to Single Nurse as ordinary income in 2022; or
- Recharacterize the $6,000 and the growth on the $6,000 as a traditional IRA by October 16, 2023. This will result in Single Nurse having a traditional IRA with a basis of $6,000; or,
- If neither Option 1 or Option 2 is timely executed by October 16, 2023, Single Nurse owes a six percent penalty on the $6,000 excess contribution ($360) and will owe an additional six percent penalty for every additional year the $6,000 Roth contribution (but not the earnings) is not withdrawn from the Roth IRA.
I do not see another administratively feasible alternative for the IRS to enforce a retroactive repeal of the Backdoor Roth IRA in 2022.
I believe the IRS and Treasury would also apply this treatment (or a similar treatment) to any split-year Backdoor Roth IRAs completed in 2022 for the 2021 tax year.
*Update 1/6/2022: Upon further reflection, I believe remedial action to correct an excess Roth IRA contribution in this hypothetical situation can occur by the extended tax return due date. See the bottom of page 42 of IRS Publication 590-A. An earlier version of this post used April 15, 2023 as the deadline date for all three remedial courses of action.
This outcome is not all that bad for Single Nurse. An opportunity taken away for sure, but the “downside” consequences are not all that deleterious. The downside appears limited to ordinary income tax on a few months of growth on $6,000.
Single Nurse’s reaction:
Possible Outcome #6: A New Version of Build Back Better is Enacted in 2022 Which Repeals the Backdoor Roth IRA Effective January 1, 2022 and the IRS Treats Early 2022 Backdoor Roth IRAs in a Different Manner
Sean’s Estimated Probability: 0.4%
This outcome accounts for the unknown. The IRS and Treasury might take a different approach than the one I outline in Possible Outcome #5. To my mind, the absolute worst outcome would be the six percent penalty tax on an excess contribution. Even then, it is difficult to imagine a scenario where the IRS would not allow remedial action to avoid the six percent penalty.
Single Nurse’s reaction:
Single Nurse’s Assessment
Single Nurse will need to make a subjective assessment of the possibilities and the risks. She is likely to assign somewhat different probabilities to the various possible outcomes than I do. Further, she will have to determine how much she values the possible benefit of an early Backdoor Roth IRA (Possible Outcome #4 in particular, and Possible Outcomes #1 through #3) versus the costs of an early Backdoor Roth IRA (Possible Outcomes #5 and 6).
My own assessment is that Single Nurse is more likely to benefit from executing an early Backdoor Roth IRA than she is to be (slightly) harmed by it, because I believe that Possible Outcome #4 is more likely than Possible Outcomes #5 and #6.
Conclusion
Of course, none of the above is advice for any particular taxpayer. Rather, it serves to illustrate how one financial planner would go about systematically assessing the probabilities, risks, and rewards associated with an early 2022 Backdoor Roth IRA.
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This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
This is an excellent article! Thanks for posting it. These are the questions I’ve been asking myself too. In short, it sounds like one needs to execute backdoor conversion asap in 2022.
Great article and helps organize the uncertainly.
I would however put more weight on #3 or this being passed in a separate retirement bill (or even attached to something seemingly unrelated). It seems like backdoor has widely been framed as a “loophole” that only benefits the “rich” or “wealthy” so it doesn’t seem like there is much political will to protect it beyond 2022.
Is there a recommended “rule of thumb” for the time between contributing to a Traditional account and conversion? In your example it was 4 full days (Jan 1 – Jan 5) and I wasn’t sure if that was just an arbitrary date or if there was logic behind it.
Thanks again!
No “rule of thumb” for time between contributing and converting. I always contributed first business day of January and converted the very next business day.
Great article regarding the back door Roth IRA conversion.
What are your thoughts regarding an individual with both Deductible Traditional IRA and Non-Deductible Traditional IRA contributions done years ago? Is a Roth IRA conversion of this money still viewed as a back door Roth IRA conversion? The IRS will not let you cherry pick which of these IRAs to convert and you must use a pro-forma calculation with the cost basis of all your IRAs. I’m debating whether to continue converting the money to a Roth IRA this year (2022) as I haven’t been able to determine if my situation is the same as a back door Roth IRA conversion. Appreciate your insight.
Harold, thank you for reading, commenting, and for your kind words.
Unfortunately, I cannot answer questions specific to a particular taxpayer’s unique situation and I cannot provide tax advice to any taxpayer on the blog.
Regarding possible outcome #5: It should be noted that roth conversions are no longer allowed to be recharacterized to traditional IRA. So, if you’re above the income limit for roths, then you ideally would contribute to traditional IRA, then convert to roth. In doing so, you cannot recharacterize back to traditional if some law changes later. You can only recharacterize if you contributed directly to the roth in the first place (no initial IRA to roth conversion).
Pierce, thank you for reading and commenting. I appreciate it.
If Possible Outcome #5 occurs, I believe the IRS and Treasury would (most likely) issue guidance treating a 2022 Backdoor Roth IRA as simply an annual contribution to a Roth IRA (which would then be an excess contribution in Single Nurse’s case). I see no other feasible regulatory path to enforcing a retroactive prohibition of the Backdoor Roth IRA.
What I didn’t explicitly lay out above is that under such a regulatory treatment, the first step of the Backdoor Roth IRA (the traditional IRA contribution) would be disregarded. Thus, Single Nurse would be left with the three options I present above, including recharacterizing the then-considered annual Roth IRA contribution as a traditional IRA contribution.
Accordingly, I believe the repeal of recharacterizations of Roth conversions should not be relevant (assuming the IRS and Treasury proceed as I predict they will in this situation).
In theory there is a fourth option available to Single Nurse, but practically speaking, it isn’t much of an option. Single Nurse can pay the 6% penalty for 2022 and then “roll over” the contribution to 2023 as a 2023 Roth annual contribution. That option isn’t at all promising if Single Nurse is likely to be above the MAGI limit on Roth contributions, since she will be subject to the 6% penalty annually until the contribution can qualify as a good annual Roth IRA contribution.
Interesting, thank you for elaborating on the potential regulatory treatment. This post was a wonderful read (and surely much needed for many of us due to the uncertainty surrounding the BBB bill).
Happy new year!
Great article. So backdoor Roth can be done for 2021 and 2022. Correct?
Just want to add a “Thank you!” for the best breakdown of this that I have read yet. Very helpful. Happy New Year.
Would there be any advantage in creating a separate Roth Ira just for a 2022 backdoor conversion? I think there would just in case it has to be undone if the BBB is passed.
Mike, you raise an interesting point. From the perspective of computing the earnings attributable to a potential excess contribution to a Roth IRA, the answer is no. The financial institution computes the earnings attributable to the excess contribution, so taxpayers do not need to worry about creating spreadsheets to do so.
However, in theory there could be a very small tax advantage to having a separate Roth IRA for this purpose if that separate Roth IRA was invested in very low yielding, very low growth securities for a while. If the transaction were to be declared an excess contribution to a Roth IRA, the taxable growth from such an investment would be very small. If the excess contribution were a small part of a larger Roth IRA that had significant growth, then the taxable growth could be a larger amount.
The above said, to my mind the tax benefits are minimal. Even in a high growth investment, how much growth can $6K generate in several months? I would not make this consideration a driver of planning in this regard, though I acknowledge that others might view it differently.
Of course, none of this is tax advice or investment advice for you or any other person.
How about investing in a separate fund in the same Roth just to track the earnings more easily? Or is the earnings calculation always based on the entirety of the holdings in the account?
Stevie, my understanding is that the earnings are computed based on the entirety of the account. See Treas. Reg. Sec. 1.408A-5 Q&A 2 and Treas. Reg. Sec. 1.408-11.
https://www.law.cornell.edu/cfr/text/26/1.408A-5
https://www.law.cornell.edu/cfr/text/26/1.408-11
Hello, Thx so much for the great article! I have been contributing the max (19.5K) over the past few yrs as post-tax dollars to my current employer-sponsored ROTH. My wife and I also have other separate traditional IRA’s from prior employers as well as a single SEP IRA. Since I contributed post-tax $ this past yr through my current employer, are we also able to convert the max $19.5K for both myself and my wife from either the traditional/SEP into our separate ROTH IRA’s without tax consequence? Also, is there any benefit to converting any additional non-ROTH balance in 2022, or did we partly miss out on that in 2021? Thx VERY much!
Ed, thank you for reading, commenting, and for your kind words.
Unfortunately, I cannot answer questions specific to a particular taxpayer’s unique situation and I cannot provide tax advice to any taxpayer on the blog.
Np at all, completely understand and apologize for that. I will reword my Q. Could someone with a previously funded traditional IRA convert some holdings in 2022 using the back door ROTH IRA without tax consequences? Thx!
Ed, like I said, I can’t weigh in on your specific situation. From an educational perspective, I believe you may find some of my previous educational writings on Backdoor Roth IRAs helpful, starting with this post: https://fitaxguy.com/backdoor-roth-iras-for-beginners/
Can traditional brokerage account be use to fund back door Roth since it is after tax.
Thanks for reading and commenting. The answer is “Yes, but”
Yes, a taxable brokerage can be the source of funds for a traditional IRA contribution (the first step of a Backdoor Roth IRA) if one otherwise has sufficient compensation for the tax year. However, a traditional IRA can only accept cash as an annual contribution (it can receive other property in a qualified rollover).
So, if a taxpayer has a taxable brokerage account invested in ABC Mutual Fund, and he purchased that mutual fund for $10K and it is now worth $20K, the taxpayer could sell $6K of the mutual fund and use the cash to fund the traditional IRA. That sale would create a $3K taxable capital gain to the taxpayer. The taxpayer cannot directly fund an annual contribution to a traditional IRA with shares of ABC Mutual Fund.
See section 408(a)(1): https://www.law.cornell.edu/uscode/text/26/408