Is the backdoor closing? If a recently released proposal from the House Ways & Means Committee is enacted, then yes it is.
My analysis and commentary below is just my initial take on the proposed new laws: it is subject to revision.
UPDATE December 18, 2021
The update as of December 18, 2021 can be read here. Turns out that as of now (December 18th) my predictive analysis offered in November appears rather spot on. But remember, things can change.
Here’s what I wrote in November: On November 19, 2021, the House of Representatives passed the proposals discussed below. To my mind, the passage of this legislation is a 26.2 mile marathon: Passage in the House is the first mile, and passage in the Senate is the next 25.2 miles. There are absolutely no guarantees as to whether the proposals ultimately become law. My view is that passage in the Senate is going to be much more difficult than passage in the House.
Backdoor Roths
The Backdoor Roth IRA has been a popular transaction for over a decade. It allows those unable to make a direct Roth IRA contribution to get an annual contribution into a Roth IRA through a two-step process. There is a 401(k) version popularly referred to as the Mega Backdoor Roth IRA, which allows taxpayers to move significant amounts into Roth accounts using after-tax 401(k) contributions.
House Ways & Means Proposal
On September 13, 2021, the House Ways and Means committee released legislative text and an explanation of proposed new rules that would change the Roth landscape.
Elimination of Backdoor Roth IRAs and Mega Backdoor Roth IRAs
Effective in 2022, after-tax amounts in IRAs could not be converted to Roth IRAs. This rule would apply to all taxpayers regardless of their level of adjusted gross income. This rule would eliminate the Backdoor Roth IRA, as amounts contributed to a nondeductible traditional IRA (the first step of a Backdoor Roth IRA) could not be converted to a Roth IRA.
The bill would also eliminate after-tax contributions to qualified plans. As a result, workplace plans such as 401(k)s could no longer offer the Mega Backdoor Roth.
Effect on 2021 Backdoor Roth IRAs
In a twist, the new rule would effectively impose a deadline on all 2021 Backdoor Roth IRA planning: December 31, 2021. If the new law is passed, both the nondeductible traditional IRA contribution step and the Roth conversion step for a Backdoor Roth IRA would need to be completed by 2021 in order to do a 2021 Backdoor Roth IRA.
Usually, the deadline to worry about from a Backdoor Roth IRA perspective is the deadline to make the nondeductible traditional IRA contribution, usually April 15th of the following year. There is no particular deadline to complete the Roth conversion step. By prohibiting Roth conversions of after-tax money in traditional IRAs beginning January 1, 2022, Congress effectively makes December 31, 2021 the deadline to execute the Roth conversion step of a 2021 Backdoor Roth IRA.
I wrote about how the legislative proposal impacts the approach to 2021 Backdoor Roth IRA planning and deadlines here.
I have previously written about late or “split-year” Backdoor Roth IRAs under current law here.
Update on Legislative Proposals (As of November 4, 2021)
On October 28th, a new tax proposal came out which did not have the Backdoor elimination proposals. However, a second new tax proposal issued on November 3rd did contain the Backdoor Roth elimination proposals. Based on the current political landscape, there is significant doubt as to whether any tax proposal is enacted during this Congress. However, there is at least some chance the Backdoor Roth proposals are enacted.
Elimination of Roth Conversions for High Income Taxpayers Beginning in 2032
The legislative proposal also eliminates Roth conversions in any year a taxpayer’s adjusted taxable income is $400K (single filers) or $450K (married filing joint) starting in the year 2032.
A couple of observations about this rule. First, this rule would have no practical effect on the FI community. Usually, those in the FI community avoid taxable Roth conversions during high income years. Taxable Roth conversions (such as the so-called Roth Conversion Ladder strategy) are usually executed during early retirement before collecting Social Security. Those years often have artificially low taxable income, so a high income cap on the ability to do a Roth conversion is a rule without consequence for the FI community.
Second, you might be wondering: why the heck are they changing the tax law 10 years in the future? Why not now? The answer lies in how Congress “scores” tax bills. Taxable Roth conversions, particularly in the near term, increase tax revenue. An immediate repeal of Roth conversions would “cost” the government money in the new few years. But by delaying implementation for 10 years, Congress is able to predict that taxpayers, facing a future with no Roth conversions, will increase Roth conversions in 2030 and 2031, increasing tax revenues in those years.
Outlook
Congress is closely divided. There is absolutely no guarantee this bill will pass both houses of Congress and be signed by the President. That said, these proposed rules are now “out there” and being “out there” is the first step towards a tax rule becoming law.
I will Tweet and blog about any future developments in this regard.
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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.
Thanks for the clarifications, Sean. When this news hit earlier this week, I was under the impression that I would still be able to execute the backdoor Roth for the next ten years. Sounds like that’s not the case after all. . .(sad face)
Andrew, thank you for reading and commenting!
Just a quick follow up question; do we have any idea when we’ll know one way or the other if this is to become law?
It is so speculative. My two cents: I think there are two potential windows: one around late September and early October, and the other at year-end. Those are, in my opinion, the likely two windows in which this might be passed, though anything is possible. The big line in the sand is end of year: it is less likely a tax bill passes during an election year.
Got it. I’ll keep my fingers and toes crossed that this fades into the ether over the next few months. 🙂
Thanks again, Sean!
I’m a little confused on these two paragraphs in their explanation. First of all, is the 2031 date in the first paragraph a typo and should be 2021? Second, is the first paragraph eliminating just to the conversion step after 2031 and the second paragraph eliminates step 1 beyond 2021? I.e. You can’t make any new after-tax contributions to a traditional IRA after Dec 31, 2021, but you could sit on a current traditional IRA (again, no after-tax contributions past 2021) and wait to complete the second step of the back-door convert to Roth until Dec 31, 2031?
“In order to close these so-called “back-door” Roth IRA strategies, the bill eliminates Roth
conversions for both IRAs and employer-sponsored plans for single taxpayers (or taxpayers
married filing separately) with taxable income over $400,000, married taxpayers filing jointly with taxable income over $450,000, and heads of households with taxable income over $425,000 (all indexed for inflation). This provision applies to distributions, transfers, and contributions made in taxable years beginning after December 31, 2031.
Furthermore, this section prohibits all employee after-tax contributions in qualified plans and prohibits after-tax IRA contributions from being converted to Roth regardless of income level, effective for distributions, transfers, and contributions made after December 31, 2021.”
Jonathan, thank you for reading and commenting!
The Ways & Means explanation is confusing (that will happen from time to time when hurriedly trying to explain an 881 page tax bill!).
They lead the “no Roth conversions for high earners starting in 2032” paragraph by talking about backdoor strategies. That lead is misplaced. That lead belonged on the next paragraph. Banning Roth conversions for those making over $400K starting in 2032 has little do with banning backdoor strategies. It’s the next paragraph, where they discuss no more conversions of after-tax IRA amounts, and no more after-tax 401(k) contributions, which discusses the rules banning the backdoor strategies.
Sean, most of the headlines and discussion I’ve seen regarding this proposed law is associated with the Mega Backdoor Roth IRA (converting after-tax 401k contributions to Roth IRA). From your understanding, would the new law also apply to in-plan Roth Conversions (converting after-tax 401k contributions to Roth 401k)?
Chris, thank you for reading and commenting on the blog. I appreciate it.
First, the new law would prohibit after-tax 401(k) contributions. So there won’t be much of an issue — there won’t be future after-tax contributions to convert. My initial understanding is that any existing after-tax contributions could not be in-plan converted to Roths under the proposal as well. Long story short — this proposal nukes the Mega Backdoor Roth regardless of whether the ultimate landing point in the Mega strategy is a Roth IRA or a Roth 401(k).
Do I understand correctly that traditional IRA pre-tax contributions transferred to a Roth is still allowed for individuals with adjusted taxable income less than $400K and that the proposed rules restricting that would begin in 2022?
Charles, thank you for reading and commenting.
The Backdoor Roth IRA will be shut down for all income levels under this proposal, which as of now is still not law. So no changes for 2021, and then we will wait and see for 2022 and beyond.
That’s the way it reads to me as well.
Sean
How would the new law handle after tax contributions made to the traditional IRA because a person has a 401k and AGI is too high for the deduction.
Also, how would the new law affect combat zone contributions to the traditional TSP for a military member. Wondering if I should move those CTZE funds from the TSP in 2021.
Thanks
Scott
Scott, thank you for reading and commenting. I appreciate it. Thank you also for your service to our country.
After-tax (nondeductible) IRA contributions would appear to still be allowable, but they cannot be converted to Roths under the new law. I am not aware that the new law impacts combat zone contributions to the TSP, but this is not something I have looked into.
And of course, by “new law” I mean “the proposal if it becomes law” — as discussed elsewhere, it is only a proposal at this point.
FITAXGUY,
Great article, my only question is in the terms.
How do we know “after-tax” dollars means money from Traditional IRAs? These are full of “pre-tax” dollars correct? Meaning they would still be able to be rolled into Roth IRAs?
Terrence, thank you for reading and commenting, I appreciate it.
Traditional IRAs can have both pre-tax dollars and after-tax dollars in them. Under the proposal, only pre-tax dollars can be converted to Roths.
Under current law, the after-tax potion of an IRA cannot be separated from the pre-tax portion during a conversion. The converted amount is apportioned between the two. Consider an example of an IRA of $100,000 with $50,000 each of pre and after tax contributions. If $50,000 is converted to a Roth, 50% of the conversion would be taxable and 50% would not be taxed. The same is true for distributions. It is not possible to withdraw only the pre or after tax portions.
How would this be handled under the proposed law for a married tax payer making less than $400,000?
Michael, thank you for reading and commenting. I appreciate it.
The proposed law would change two things (discussed below) about the taxpayer your are considering from 2022-2031. Further, during those years, their taxable income would be irrelevant ($0 or $1 billion, same tax rules apply).
In your example, there is an IRA, worth $100K, with $50K of nondeductible after-tax contributions. The first change is that taxpayer would be limited in the amount they convert from a tIRA to a Roth IRA: $50K. That would be their maximum conversion amount.
Second, the proposed law repeals the Pro-Rata Rule* in cases of Roth conversions and replaces it with a rule that ONLY the pre-tax amounts can be converted. As a result, every dollar that taxpayer converts would be fully taxable. The other $50K (the historic nondeductible tIRA contributions) are (sort of) trapped inside the tIRA. The only way to take them out is through a direct withdrawal that cannot be converted to a Roth.
Starting in 2032, the proposal adds a third rule for this taxpayer: if their income is $400K (single) or $450K (MFJ) or more, they are not able to do a Roth conversion of any amount.
*Interestingly, the Pro-Rata Rule would survive for regular distributions. Could add some complexity when tackling years with both Roth conversions and regular distributions, though a small benefit of doing Roth conversions would be that regular distributions would attract more basis because the Roth conversions would (presumably) chip away at the denominator in the year of the conversion for Pro-Rata Rule calculation purposes.
WOW! You provided an excellent explanation to a complex question (that was probably not well framed). Thank you!