“Backdoor” and “mega-backdoor” Roth accounts and other tools of wealthy clients for building giant nest eggs without paying taxes, could be in danger.
Congress is considering banning both kinds of Roth strategies starting next year. Lawmakers are also debating requiring huge distributions from the accounts and curtailing contributions to vehicles that have more than $10 million in holdings. Other proposed measures would kick in further in the future.
Combined, the limitations could eventually affect distributions, contributions and tax advantages for wealthy Roth owners.
Roth conversions allow for converting funds in a pre-tax individual retirement account or 401(k) to an after-tax Roth IRA. Investors owe tax on the converted money but the Roth IRA then grows tax-free. Democratic lawmakers want to end Roth conversions with pre-tax money for the wealthy.
Proposals call for ending such conversions for those whose adjusted gross income exceeds $400,000 (for single filers) or $450,000 (for married filing jointly), starting in 2032.
But a special kind of account is grabbing headlines. Though the conventional version of the Roth has income limits too low to allow use by wealthy clients, backdoor Roths have been a popular legal workaround that enables high-income investors to sidestep income restrictions.
In a backdoor Roth, investors who earn too much to contribute directly to a Roth IRA make after-tax contributions to a traditional IRA and then convert the contributed amount to a Roth IRA. The “mega backdoor Roth” conversion is similar but starts with a workplace retirement plan such as a 401(k) or 403(b).
Changes are under discussion to ban backdoor and mega-backdoor Roths after Dec. 31.
Some claim that Democrats’ Roth-related proposals would impact only a few Roth owners and that a ban on future Roth contributions for wealthy account holders would have an negligible effect on the overall value of such accounts. Proponents counter that the measure would go far toward helping fund President Biden’s $3.5 trillion American Families Plan.
Nevertheless, it’s apparent that chances to take advantage of this “powerful planning technique” may be disappearing, said Kara Harmon, partner at Moneta in St. Louis.