While Congress continues to debate and negotiate tax legislation, retirement savers still have an opportunity to take advantage of certain tax strategies that could soon disappear. One provision that is very likely to be eliminated is the back-door Roth IRA. This strategy allows high-income earners to create tax-free retirement income. The next few months could be the last chance for some taxpayers to use this powerful strategy.
What is a Roth IRA?
Roth IRAs were created in 1997 as an alternative to the traditional, tax-deductible IRA. Unlike traditional IRAs, there is no immediate tax deduction for making a Roth contribution. However, funds contributed to a Roth can be withdrawn at any time without penalties. Earnings withdrawn from a Roth are tax-free as long as the account has been open for five years and the account owner is over age 59 ½. Roth earnings can also be withdrawn tax-free in the event of death or disability. Up to $10,000 can be withdrawn tax-free for a first-time home purchase. The combination of tax-deferred growth and tax-free withdrawals makes Roth IRAs a powerful wealth-building tool.
Limits and Loopholes
The legislation that created Roth IRAs contained provisions to limit the use of these accounts by high-income earners. In 2021, most taxpayers can contribute up to $6,000 to an individual retirement account. This can be a Roth contribution, a traditional contribution, or split between the two types of IRAs. An additional $1,000 contribution is allowed for savers who are 50 or older by December 31.
However, these limits are reduced or eliminated for taxpayers with income over certain limits. Single taxpayers who earn over $125,000 have lower contribution limits, and for those with income over $140,000 no contribution is allowed. For married taxpayers who file a joint return, contributions are limited starting at $198,000 of income and phased out completely at $208,000 of income. The income used for these tests is called Modified Adjusted Gross Income, or MAGI. Ask your tax advisor if you’d like to learn more about how MAGI is calculated.
In 2005, Congress created a loophole allowing high-income taxpayers to work around these limits. The loophole, which eliminated income limits on Roth conversions, became effective in 2010. Conversion is the process of turning a traditional IRA into a Roth IRA. Deductible contributions and earnings in the traditional IRA are taxable on conversion.
The 2010 rules created a new strategy: high-income individuals could make full, annual, nondeductible contributions to a traditional IRA and convert those contribution dollars to a Roth. If the account holders had no other IRAs and the conversion was executed quickly enough so that no earnings were able to accrue, the transaction could potentially be a tax-free way for otherwise ineligible taxpayers to fund a Roth IRA. This loophole became known as the back-door Roth IRA.
The back-door Roth works best for savers who do not have traditional IRA balances. However, there are some advanced strategies that can create the opportunity for a back-door Roth even if you have existing traditional IRA assets.
No one knows how or when Congress will settle debate and pass new tax legislation. The current proposals would end the back-door Roth IRA strategy after December 31, 2021. For high-income taxpayers, the next few months may be the last opportunity to use the back-door strategy. The back-door Roth process can be complicated, especially if you have existing traditional IRAs. Seek the advice of an experienced tax and financial advisor for more information.
Matthew A Treskovich | CFA, CPA/PFS, CITP, CMA, CFP®, AEP®, MBA, CLU, ChFC
Chief Investment Officer