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What to Know About a Backdoor Roth

The purpose of having a Roth IRA is to save for your own retirement and provide retirement security. The advantage of using a Roth IRA is being able to make tax-free qualified withdrawals. Unlike a traditional IRA, contributions to a Roth IRA are taxed before they go into the account.

One legislative reform up for consideration would end “backdoor” and “mega backdoor” Roth strategies for the wealthy, and add new contribution rules for individuals exceeding $10 million, thus prohibiting wealthy individuals from contributing extra savings.

A backdoor Roth applies to people whose incomes are above the IRS limits. For example, in 2021, a single taxpayer can’t add money to a Roth IRA if their income exceeds $140,000.

When using a backdoor Roth, you roll money over from a traditional IRA to a Roth account. You won’t have to pay taxes on your retirement savings in the Roth IRA when it’s time to make withdrawals and you’re not subject to required minimum distribution rules.

But the catch is you pay income tax on the money you roll over to a Roth account. So while you could save money on taxes in retirement, you can’t escape the tax liability of a traditional IRA altogether.

The bill would also repeal Roth conversions in individual retirement accounts and 401(k)-type plans for those single taxpayers making more than $400,000 a year. For married taxpayers filing jointly, the threshold is $450,000 and for heads of households, $425,000.

This also prevents savers from using the next approach, regardless of their income levels.

A mega backdoor Roth is defined as a unique 401(k) rollover that’s designed for high earners who have a 401(k) plan at work. It allows earners to save up to $58,000 in a 401(k) plan (rather than $19,500) using what’s called an “after-tax 401(k) bucket” to convert their savings to a Roth.

House Democrats want to end the mega-backdoor Roth by eliminating the ability to convert after-tax contributions in both workplace plans and IRAs to a Roth IRA.

The policy would apply at the same income thresholds listed above and would count for distributions, transfers and contributions made in taxable years beginning after Dec. 31, 2031. But regardless of income level, the proposed policy would apply to everyone.

The Broader Theme

Accredited investors seeking to buy a private investment won’t have an easy time either. The Democrats’ proposed legislation clearly bans IRA investments that require the owner to have a minimum level of assets or income, or to have completed a minimum level of education or obtained a specific license or credential.

So, basically, IRAs with these investments would lose their IRA status — meaning they’d lose their tax benefits. Although these rules will apply starting in 2022, there is a two-year transition period for IRAs already holding these investments.

Keep in mind, Hefren-Tillotson advisors as well as many other advisors recommend Roth conversions when it makes sense in financial plans. This is another layer of planning.

And it is all part of a broader theme of raising taxes on those who earn more than $400,000 annually to help pay for education, climate, paid-leave, child-care and other measures while also making the tax code more equitable.

“These life-changing provisions will level the playing field, expand opportunity and rebuild our economy to be more equitable and inclusive,” Chairman Richard Neal, D-Mass., said in a statement.  

As you know, Roth IRAs are neither except from federal and state tax, nor subject to required minimum distributions rules that typically apply to traditional IRAs. 

The top tax rate proposed on capital gains and qualified dividends would rise up to 28.8%.

The top federal rate would be 25% on long-term capital gains, from 20%, added to the existing 3.8% surtax on net investment income, would come in at 28.8% and apply to stock and other asset sales that occur after Sept. 13, 2021.

If you have questions or would like more information and how legislative changes might affect you and your situation, please contact us at Hefren-Tillotson today. We would be happy to help.

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