Starting in 2021, the Backdoor Roth IRA has allowed all income earners the ability to make a Roth (After tax) IRA contribution. Prior to 2010, any taxpayer that had income above $100,000 was not allowed to do a Roth IRA conversion which prevented people from making an after-tax IRA contribution and converting to a Roth.
For high income individuals, contributing funds to a Roth IRA is only possible through a solution known as the “Backdoor” Roth IRA. In 2022, the maximum Roth IRA contribution limit was $6,000, or ($7,000 if 50+). This is because the IRA rules impose income limitations on Roth contributions but no longer include income limitations on Roth IRA conversions.
In 2022, If you earn more than $214,000 and are married -file jointly, you are not allowed to make Roth IRA contributions. If you are single and earn more than $144,000 the same holds true for you. However, under the “Backdoor” Roth IRA strategy, those who earns more than the Roth IRA income limitations (i.e., $214,000 in 2022 and married and filing jointly), can make an after-tax IRA contribution and then immediately convert the funds to Roth.
How does a Backdoor ROTH IRA Work?
After-tax contributions are traditional IRA contributions that are not tax-deductible. The income and gains on traditional after-tax contributions are subject to tax. Thus, making Traditional after-tax contributions other than for purpose of a “Backdoor” Roth IRA contributions does not make much sense. In essence, it is the worst option since an after-tax contribution is not tax deductible and the income and earnings are subject to tax, as well as a 10% early distribution penalty, if applicable.
Below is an example:
Elaine is married, and she and her husband have income over $250,000. Elaine could not make a Roth IRA contribution due to her high income. Thus, Elaine can make a traditional IRA contribution and not take a tax deduction (after-tax contribution) and can then immediately convert the after-tax funds to Roth. There would be no tax on the conversion from after-tax to Roth, although, if Elaine had other pretax IRAs at the time of the conversion, the amount converted to Roth could be limited based on a pro rata conversion requirement.
If Elaine wanted to make a Backdoor Roth IRA contribution of $5000 in 2022 but had a Traditional IRA worth $5,000 she started in 2015. Under the pro rata conversion rule, only 50% of the $5000 Backdoor Roth IRA contribution from 2022 would be deemed Roth. The pro rata backdoor Roth IRA rules work as follows: if you have Traditional IRA contributions from past years: (i) add all Traditional IRA contributions and (ii) divide by amount of current year after-tax IRA contribution. Then take that percentage and multiply against current year backdoor IRA contribution. That amount will be deemed converted to Roth from the after-tax contribution amount.
The Roth IRA Advantage
The major advantage of having a Roth IRA is that all income and gains can be distributed tax-free if you are over the age of 59 1/2 and the Roth IRA has been opened at least 5 years. Simply put, the Roth IRA distribution would not be subject to any income tax or capital gains so long as the Roth IRA holder is over the age of 59 1/2 and the Roth has been opened at least five years. Another advantage is that Roth IRAs are not subject to any required minimum distributions.
Build Back Better and Beyond…?
In November 2021, the House narrowly passed the Build Back Better (“BBB”) bill, the centerpiece of President Biden’s domestic agenda, approving $2.2 trillion in spending over the next decade to battle climate change, expand health care and reweave the nation’s social safety net, over the unanimous opposition of Republicans. However, as a result of Sen. Joe Manchin, D-W.Va opposition, the Bill was not able to pass the Senate and currently in “pause.” The Bill contains a number of retirement related provisions, including a provision that would eliminate the conversion of after-tax contributions to Roth for 2022 and beyond, and as a result, killing the Backdoor Roth IRA solution.
Will the BBB be passed in 2022 and will the bill eliminate the Backdoor Roth IRA for 2022 and beyond? Nobody knows, but there is a good chance some revised form of the BBB will pass the Senate in 2022, and a strong chance the BBB will include a provision eliminating the Backdoor Roth IRA. Although, it is unclear if the provision would apply to 2022 or be pushed back a year until 2023. The belief is that if the BBB does not get passed before March 2022, there is a solid chance the Bill will allow for Backdoor Roth IRA conversions in 2022, but eliminate them for 2023 and beyond.
Conclusion
As of February 2022, the Backdoor Roth IRA is still alive. Therefore, any taxpayer making more than $214,000 in income and is married and filing jointly can make an after-tax Traditional IRA contribution and then potentially do a tax-free Roth IRA conversion.
Douglass Belt LUTCF, BFA is an independent Financial Advisor at WestPoint Financial Group. Doug is licensed to sell insurance in: WI, IL, MI and securities in: WI, AZ & MN. Doug is a registered representative of MML Investors Services, LLC, Member SIPC (www.sipc.org). Supervisory address: 525 Junction Rd Madison WI 53717