Changes may be in store when it comes to the way you save for retirement. Many investors have come to rely on the “backdoor” Roth IRA as a means to avoid the Roth’s traditional income limits. But the Build Back Better bill has some investors wringing their hands regarding the future of this strategy.
What is a backdoor Roth IRA? Is the backdoor Roth IRA going away? We’ll explore these questions and more, so you have a better handle on your investment plan moving forward.
The term “backdoor Roth IRA” doesn’t actually refer to an investment vehicle. Instead, it refers to the process of creating a permanently tax-free Roth IRA.
The Roth IRA has long been an attractive savings vehicle for many Americans, since it allows users to make tax-free withdrawals down the line free of federal income tax, regardless of how much money is in the Roth account.
Ordinarily, a Roth IRA has income limits that prohibit high-earners from opening or funding these accounts. But a traditional IRA has no such limitations, nor are there prohibitions on converting a traditional IRA to a Roth IRA.
Therefore, high earners have opened a Roth IRA through a “backdoor” approach: making a non-deductible contribution to a traditional IRA and then converting it to a Roth.
Let’s take a closer look at how a backdoor Roth IRA works, practically speaking. In order to open a backdoor Roth IRA, you’ll simply do the following:
- Make a non-deductible IRA contribution to your traditional IRA
- Keep the non-deductible funds in your traditional IRA for at least one full day
- Convert your traditional IRA to a Roth IRA
Keep in mind that if your 401(k) account allows conversions, you can likewise roll these retirement savings into a Roth account.
Roth IRAs came onto the scene in the late 1990s as a means of helping the middle class save for retirement, covering lingering debt or the remainder of their mortgages. But some legislators have concerns that the uber-wealthy have abused this system for their own financial gain.
The House-passed Build Back Better bill would prohibit taxpayers from converting after-tax savings to a Roth IRA starting in 2022, regardless of their income level. An additional provision will prevent any Roth conversions by anyone making over $400,000 (or couples earning over $450,000) by 2032.
According to reports from CNN, it’s not immediately clear when the effective date will be for some of these new changes. It’s actually possible that these changes won’t officially go into effect until 2023. The reason, as you may have guessed, has to do with continued political disagreement regarding other sections of the much-debated bill. Hence, discussions are ongoing and are likely to continue into 2022.
But it’s safe to assume that the backdoor Roth IRA is something of an endangered species. As of this date, investors can continue using this method, but the clock is ticking on the longevity of this strategy. It’s not immediately clear when there will be a resolution regarding Build Back Better legislation.
While uncertainty remains about the future of this bill, there are four possibilities for the immediate future:
It’s possible that the law will not change until 1/1/2023. Given that things have not changed yet, this gives you time to continue using the backdoor method of establishing Roth accounts. Keep in mind that you’d be betting on the possibility of having a remaining year to do so.
It’s equally possible that there will be a resolution on the bill at some point in the next year – maybe even the next few months. This means that the best time to attempt a backdoor Roth IRA is now, before any of these proposed changes occur.
It’s also possible that the changes will go into effect retroactively, making 1/1/2022 the effective date at which backdoor Roth IRAs became a thing of the past.
If you make a conversion after this date, but before the law makes them illegal, you might be given an exemption, though this is far from clear.
Of course, there’s always a chance that legislators will reach a stalemate, which could mean that the law wouldn’t be changing at any time in the near future. But this is far from a certain outcome.
It’s always best to be prepared for change. At Runey and Associates, we want you to have the knowledge and tools to plan for retirement and make worthwhile investments, regardless of the changes that might come your way.
If you’re looking for a financial planner in the Charleston area, rely on our solid team of friendly professionals. Contact us today to learn more about the latest tips and techniques for funding your retirement. We look forward to serving you!