Roth IRA Tactics in an Ambiguous Fight
The Beltway brawl over the Build Back Better Act (BBBA) continues and the tea leaves* currently indicate that the law won’t pass until some time in 2022, if at all. This political impasse creates an interesting ambiguity for Backdoor Roth IRA aficionados. Thus, what follows is what I think, when I think about Roth IRA tactics in this ambiguous environment.
*If “economic forecasting exists to make astrology look respectable,” does political forecasting exist to make economic forecasting look respectable? Things that make you say, “hmmm?”
Backdoor Roth 101
On the off chance that you don’t spend 69% of your free time reading about types of IRAs, let’s do a quick vocab review. For simplicity, all examples will assume a married couple, filing jointly, under age 50 in 2022.
- Traditional IRA: Assuming your employer offers a retirement savings plan, such as a pension, 401(k), TSP, SIMPLE IRA, etc., then if your income is below $109K, you can contribute and deduct from your income, $6,000 per spouse. (The IRS will probably notice if you try to claim more than one spouse, and there are other rules too, but this suffices for most situations.)
Both the contribution and earnings grow tax-deferred until you begin to take distributions later in life.
- Non-deductible Traditional IRA: If you’re over the $109K-$129K phaseout for a deductible Traditional IRA, you can still contribute and the earnings will be tax-deferred until you take distributions.
- Roth IRA: If your income is below $204K, then you can contribute $6,000 for each spouse to a Roth IRA. You’ll pay tax on the contribution, but qualified distributions in retirement are tax-free for both the original contribution and the earnings. There is a phaseout from $204K to $214K, such that you could contribute less than $6,000 to a Roth IRA, but for the hassle, many would opt for a Backdoor Roth IRA.
- Backdoor Roth IRA: A Backdoor Roth IRA is just a conversion from a Non-deductible Traditional IRA to a Roth IRA, usually in short order. The IRS legitimized this tactic in 2018 when it said the “Step Doctrine” didn’t apply. Usually, a Backdoor Roth IRA looks like:
- Day 1: Contribute $6K to Non-deductible Traditional IRA
- Day 2: Convert the $6K to your Roth IRA
- April 15th next year: File form 8606 with your tax return
Many details bedevil the process, and the main one is this: the balance in ALL of your Traditional IRAs (e.g., SEP IRA, SIMPLE IRA) must be $0 prior to the $6K contribution. Otherwise, any conversion will invoke the “pro-rata” rule such that a conversion will be pro-rata between pre-tax and after-tax dollars.
The Backdoor Roth is extremely popular with high-earning families because it circumvents the Roth IRA contribution limit and enables sizeable piles of tax-free income in retirement.
The Build Back Better Act and the Backdoor Roth IRA
Most experts expect that the Senate version of the BBBA will match the House version and eliminate the Backdoor Roth IRA (and its cousin—the Mega Backdoor Roth IRA). The specific language will prohibit the Roth conversion of after-tax “basis” in both IRAs and employer defined contribution plans (e.g., 401(k)’s that allow additional employee after-tax contributions)
If the law passes in 2021, the expectation is that December 31st, 2021 will be the last date at which such a conversion can take place. After that, all after-tax basis in retirement accounts would have to come out in pro-rata fashion as distributions, not conversions to Roth IRAs.
Since September 2021, this has seemed like a done deal. Now that it appears that the BBBA will pass sometime in 2022 at the earliest, what are the implications for a Backdoor Roth IRA?
Scenario 1: Early BBBA Passage in 2022
Assuming that the BBBA still kills the Backdoor Roth and it passes within the first few days of 2022, I don’t expect that Congress will mind that some people will have inevitably executed their 2022 Backdoor Roth IRA already, as early as January 3rd (the first business day of 2022).
The law might still use December 31, 2021, as the cutoff, which will require the IRS to publish guidance for Backdoor Roth IRAs initiated after the deadline. This would likely take the form of taxpayers having to remove the contribution from their Roth IRA, perhaps paying tax on any earnings and an extra 10% penalty tax for a pre-age 59 ½ withdrawal.
It’s likely that a taxpayer could then proceed with an alternate investment strategy for those $6,000.
If the law uses its passage date or some later date in the year, then those who execute a Backdoor Roth IRA early in the calendar year might benefit from quick action. Those who delay… not so much.
Scenario 2: BBBA Passage Later in 2022
The later in the year that the law passes, the less likely it is that the Backdoor Roth cutoff remains December 31, 2021. Not that I expect Congress or the IRS to shed a tear, but it will be an unholy mess for custodians to clean up with hundreds of thousands of Backdoor Roth reversals.
Thus, if the law looks to pass comfortably into 2022, it may be that part or all of 2022 will be green-light go for Backdoor Roth IRAs.
Scenario 3: No BBBA Passage in 2022
This would be great news for mid-to-high income savers as the Backdoor Roth would have a new lease on life. That said, Congress has telegraphed its intent to raise future revenue by eventually killing the Backdoor Roth. It’ll be important to keep an eye peeled for future legislative attempts to shut the Backdoor.
Investing in a Post-Backdoor Roth IRA World
Let’s assume that at some future point, the Backdoor Roth IRA goes away. Should investors put their $6,000 (or whatever the annual IRA limit is) into a Non-deductible Traditional IRA (assuming the law allows it) in order to at least defer taxation on the growth? Say it with me now, “it depends.”
Non-Deductible Traditional IRA Benefits
If you choose to put your contribution into a Non-deductible Traditional IRA and let it grow tax-deferred until retirement, you’re largely in the same situation that you would have been if you had been able to deduct the IRA contribution to a Traditional IRA, except that a small percentage of your IRA won’t be taxable upon distribution… if it’s properly tracked over the decades.
Assume a 40-year-old steely-eyed killer contributes $6,000 to the Non-deductible Traditional IRA, it grows at a nominal 9% for 32 years and s/he takes the first distribution at age 73 due to RMD (required minimum distribution) rules. The account has $103,092, and the RMD is $4,173. Only $3,922 is taxable because the distribution is pro-rata.
$6,000 ÷ $103,092 = 6%
$4,173 * (1 – 6%) = $3,922
The key question is, what is the tax rate? If this steely-eyed killer has a military pension, there’s a strong chance that it’s at least 25% for federal income tax, plus any state income tax. Let’s call it an optimistic 25% and the bill is about $980.
While it’s often bandied about as axiomatic truth, delaying tax payment until the future in order to both hope for lower tax rates and pay with inflated (less valuable) dollars is only beneficial if you plan to pay taxes at all.
Traditional IRAs, deductible or not, have RMDs. If a balance remains when you pass away, your non-spouse heirs most likely have a maximum of 5-10 years to consume the balance, paying tax at their marginal rates on each distribution.
Taxable Account Benefits
Instead of investing in Non-deductible Traditional IRA, you could choose to put that $6,000 into a taxable account. Using the same numbers as before, at age 73, the balance would be $103,092, but there would be no required distribution.
Let’s assume that this 73-year-old washed-up fighter pilot does take a distribution of $4,173. The whole amount would be taxable, but the federal capital gains tax rates or 0%, 15%, or 20% would apply and the tax bill would be $0, $626, or $834.
It’s possible that state capital gains tax rates and other taxes like the Net Investment Income Tax (NIIT) might apply too, but the base rate for capital gains under current law is still likely to be lower than ordinary income rates.
Now the account is called “taxable” for a reason. Depending on the investments inside the account such as stocks, bonds, mutual funds, ETFs, etc., the investor could be on the hook for taxes each year on dividends or capital gains that the investment pays.
This problem can be mitigated by choosing long-term investments that pay minimal capitals gains or dividends such that the gains come primarily from growth of the share price. If the investor’s marginal rate is already high, tax-free municipal bonds could be worth a look.
The taxable account does not have a required distribution—ever. It can be left to heirs who can also let it grow if it’s not needed. What’s more, the assets receive a step-up in basis when you die.
Assume you purchased a hypothetical stock with the ticker RAGE for $10 per share. When you die, the value of RAGE shares is $100. Your heirs don’t pay capital gains tax on the $90 gain, they receive the shares with a newly stepped-up basis of $100. They can sell immediately for a $0 gain or accept the stepped-up basis and reduce their own tax bill.
Cleared to Rejoin
The crystal ball remains Code 3, so it’s impossible to know what will happen in the coming weeks for the Backdoor Roth IRA. It’s a reasonable assumption that Congress will maintain its Targeted role on this popular tool, so even if the Backdoor stays open for another year, its time is likely drawing to a close.
Investors that move quickly to try a Backdoor Roth in early 2022 might get a bonus year of extra Roth contributions, or they might get a lot of hassle trying to remove and pay taxes on what becomes an excess contribution. Do you feel lucky?
In a post-Backdoor Roth IRA world, Non-deductible Traditional IRAs are still a very good option for deferring taxation and taxable accounts can be very tax-efficient, especially from a generational perspective.
The key thing is to know how much to save for your future needs and stay up to date on tax policy so you can always max-perform your dollars.
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