This month may be the last chance for high-income savers to take full advantage of the ‘backdoor’ Roth.
If the Build Back Better bill, passed by the House in November and now under consideration by the Senate, becomes law, it could limit high-income savers’ options to convert their savings into Roth IRAs and Roth 401(k)s, which offer tax-free withdrawals in retirement.
The most immediate restriction, unless lawmakers amend the date, would start in 2022, when you would no longer be allowed to convert after-tax contributions – say from a non-deductible IRA – into a Roth.
Converting to a Roth would let your money not only grow tax-free but also would let you make tax-free withdrawals too. Having that option makes sense if you expect to be in a higher tax bracket in retirement or if you want greater flexibility to decide when to tap different pots of money for different purposes in retirement or at any other point.
What high-income savers can do now
Since the law has not yet changed, high-income savers can still take steps to maximize their 2021 Roth options.
You may contribute up to $6,000 (or $7,000 if you’re at least 50) into a traditional or Roth IRA. But if your modified adjusted gross income is $140,000 or more ($208,000 if married filing jointly) you can’t contribute directly to a Roth in 2021. And if you are covered by a retirement plan at work and your income is $76,000 or more ($125,000 if married) you’re also not allowed to make deductible contributions to a traditional IRA either.
In both cases, however, you may make after-tax contributions to a traditional IRA. And you can then immediately convert those contributions into a Roth IRA.
While technically you can make your 2021 contributions as late as April 15, 2022, conversions must be done – or at least be in process – by December 31 in order to count for this year, before any potential restrictions take effect, said California-based certified public accountant Mary Kay Foss.
But typically a conversion can be made in a day or two. “It’s very fast,” Foss said.
The tax bite
The immediate rub, though, is that you likely will owe tax on at least a portion of the money you convert – even if all you convert are your after-tax contributions.
To determine how much tax you’ll owe on your after-tax contributions, the IRS uses a pro-rata rule, which calculates what you’re converting as a percentage of all your IRA balances.
Here’s how it works: Say you’re 51 and make a $7,000 after-tax contribution this year to a non-deductible IRA, but you also have pre-tax traditional IRA savings of $63,000. Under the pro-rata rule, the after-tax portion ($7,000) represents 10% of your total IRA savings ($70,000). So when you convert this year’s contribution to a Roth, only $700 will be converted tax-free; you will owe income tax on the other $6,300. And you’ll have to pay that tax by April 15, 2022.
While that sounds like double taxation, technically it won’t be because the remaining portion of your after-tax contributions will eventually reduce the taxes you pay when you make taxable withdrawals in retirement. “The remaining basis from your nondeductible IRA contribution is taken into account when you make later IRA withdrawals. It isn’t lost forever,” Foss said.
And of course, if you’re also converting pre-tax IRA savings to a Roth, you will have to pay income tax on those as well.
There is one way to avoid the pro-rata rule. If your employer lets you roll over your IRA savings into your 401(k), and you can do so before December 31, then effectively you will not have any other IRA savings other than the $7,000 after-tax contribution for 2021 to convert. So in that instance, 100% of your conversion to a Roth IRA this year will be tax-free.
Get good advice before acting
The specifics of your situation may be more complex than the examples above. And the IRS rules governing different types of IRAs – especially Roths – are very complex, and never more so than when you’re moving money from one to another.
This is also the case if you’re thinking about converting after-tax savings in your qualified retirement plan at work into a Roth 401(k), should your employer offer the option of making voluntary after-tax contributions. The advantage of Roth 401(ks) over Roth IRAs is that there are no income eligibility rules and you may contribute much higher amounts annually. As with the Roth IRA, restrictions for Roth 401(k)s would kick in as early as next year under the House-passed Build Back Better bill should it become law.
So before making any moves, consult with a savvy tax and retirement adviser who can guide you through your options and help you think through the tax consequences both now and in retirement.