The clock may be ticking on backdoor Roths. The latest proposal (under a House of Representatives bill submitted on November 19, 2021) would eliminate both the regular backdoor Roth and the mega-backdoor Roth next year for everyone, regardless of income.
Roth IRA contributions are subject to income limits. For 2021, a Roth contribution cannot be done when income exceeds $208,000 (for those who are married and filing jointly) or $140,000 (for a single person).
But for those who don’t qualify to make a Roth contribution, there is an accepted workaround that over the years has been dubbed the “backdoor Roth.” Instead of contributing to the Roth IRA directly, clients first contribute to a nondeductible traditional IRA (traditional IRAs have no income limits), and then those funds are converted into Roth IRAs (conversions also have no income limits).
The House bill also includes income limits that would disallow even pretax Roth conversions (when income exceeds $400,000 for single filers and $450,000 for couples), but there’s no immediate need to worry about this becoming law, because that provision would not be effective for 10 years, and apply to the years after 2031. By contrast, the ban on after-tax conversions would be effective next year and would affect everyone, not just high earners.
The IRS has no problem with the backdoor Roth, as some people have worried about over the years. It’s legal. Both the IRS and Congress have said so. In fact, with this proposal to ban them, Congress has indirectly considered them legal, because if they weren’t, lawmakers would not have had to create a law to ban them.
Some advisors over the years have been cautious about doing the backdoor Roths when the conversions were done right after the contribution. The IRS apparently has no problem with this either, which was demonstrated by the recent Private Letter Ruling (PLR 202146009), where the Roth conversion was to be done “immediately” after the contribution. In the ruling, a couple of taxpayers had incorrectly made the initial contribution directly to the Roth IRA instead of to the traditional IRA, and the IRS gave them more time to undo (recharacterize) the contribution, even though they stated that their intent was to contribute first to a traditional IRA and then “immediately convert these contributions” to Roth IRAs for each spouse.
Of course, if the House bill becomes law, this concern would be moot anyway.
For 2021, the backdoor Roth can allow a client to move $6,000 (or $7,000 if the client is 50 or over) to a Roth. Each person in a couple can also move this amount, meaning as much as $14,000 can eventually end up in the Roth IRA.
Now that the SECURE Act has lifted the age 70 ½ restriction on traditional IRA contributions, even older high-income taxpayers can take advantage of the backdoor Roth--at least for 2021. And a couple with a non-working spouse can double the benefit (again, at least for 2021) by having each spouse make a nondeductible IRA contribution and then convert. (The non-working spouse’s contribution can be based on the working spouse’s income.)
But the big money would be in the mega-backdoor Roth. This would be available to employees where the 401(k) plan allows after-tax funds of up to $58,000 for 2021 to be contributed and then converted to a Roth IRA. The conversion would be tax-free, assuming these aren't earnings. Not everyone can do this, though, because many people do not have the available funds to make the after-tax plan contributions, and some plans don’t allow after-tax contributions. But clients who can do this should act before year's end.