If so, what do I do now?
The backdoor Roth is a well-known strategy used by high-income earners to minimize the tax paid on the growth of their investments. The American Families Plan, proposed by the Biden administration in April of 2021, has the approach directly in its crosshairs.
Will it be eliminated? We won't know until the powers that be have cast their votes, but it is a core component of the legislation.
Let's dive in on what a backdoor Roth is and, more importantly, what to do if it is eliminated.
What Is The Backdoor Roth?
A Roth IRA allows for the investment of post-tax income (up to $6,000 per year) that benefits from tax-free growth and withdrawals. A traditional IRA, on the other hand, is funded with pre-tax dollars and offers tax-deferred growth—taxes would be paid at the time of withdrawal.
Presently, Roth IRA's are limited to individuals with an annual income of $140,000 or less for single filers, or $208,000 if married filing jointly. Income limits for Traditional IRA contributions are more flexible than income limits for Roth contributions. Individuals whose income is too high for Roth contributions may contribute funds to a Traditional IRA, but again, they will have to pay taxes on the gains at the time of withdrawal.
The backdoor Roth is a method for high-income earners to contribute after-tax funds into their Traditional IRA accounts and convert them to a Roth for the tax benefits. It is a relatively simple process that essentially eliminates the tax paid on investment growth.
Why Is the Door Closing on The Backdoor Roth?
The backdoor Roth is controversial because the strategy has been used on a widespread basis to evade income limits on Roth IRA contributions. If you're not allowed to contribute to a Roth IRA due to your income, converting the Traditional IRA into a Roth IRA circumvents the rule entirely.
The American Families Plan opposed by the Biden administration in April of 2021 seeks to eliminate the Backdoor Roth. The proposal aims to eliminate this allowance for two primary reasons:
- To help offset the $1.8 trillion of spending outlined in the bill.
- To level the playing field and minimize the wealth divide.
Whether or not the expectations of the bill are necessary, realistic, and achievable is a different conversation altogether, but suffice it to know that eliminating the Backdoor Roth is very much on the radar of lawmakers. Therefore, those presently making use of the strategy should evaluate other options.
What Happens If It's Eliminated?
If the bill eliminates the backdoor Roth, investors will need to rethink their strategies. Nobody likes to pay taxes. If legal opportunities exist to minimize our tax obligation, we're going to make use of them. Tax reduction strategies are not unfair. They are simply sensible.
The question now becomes, "What do I do if the backdoor Roth is eliminated?"
If this comes to be the reality, it will not happen overnight. It will likely become effective in 2022. Let's look at two strategies for this tax year and then explore options moving forward.
- Do Nothing: The first and most apparent immediate strategy is to simply do nothing. For those who have already made use of the backdoor Roth this year to mask their investment growth from tax obligations, you're done!
- Adopt the Strategy While You Can: If you have not yet contributed to a Roth IRA or had not known of the strategy, you may want to take advantage of the approach before the door closes.
- Complete a Mega-Backdoor Roth Conversion: Like the backdoor Roth, a mega-backdoor Roth conversion employs the same strategy with after-tax contributions to a 401k. If you've already met the $6,000 annual Roth IRA maximum for 2021, this can allow additional tax-free growth. The approach was dubbed "mega" because it allows for up to $38,500 to be contributed.
Depending on your income level and needs, it may even be worth accelerating next year's income to take advantage of these approaches while they are still viable.
Strategies for High Earners in a Post-Backdoor Roth World
Tax laws are ever-changing. Wise investors understand this and expect the need to adapt! Here are two strategies in place of, or in addition to, the backdoor Roth.
- Minimizing AGI
The ever-present strategy will remain king.
Maximizing appropriate deductions as a means to reduce AGI will be an ongoing approach to lowering your tax exposure. Make use of Biden-era initiatives such as deducting 100% of business meals. Start paying attention to the smaller deductions that add up over time.
- Maximizing HSA's
If you have access to a Health Savings Account, use it as a tax-free investment vehicle! HSA's users fund the account with pre-tax dollars, which helps reduce their AGI, as mentioned above. Then, they are reimbursed for qualifying medical expenses. In the meantime, the funds in the HSA can be invested.
Reimbursements can be requested at any time. It does not have to be immediately following the expense. By paying medical expenses out of pocket (making sure to keep good records and receipts), you can defer reimbursement, allowing your pre-tax money to grow tax-free.
What's even better?
Distributions for qualified medical expenses are also tax-free. So, save those funds for post-retirement medical expenses to maximize your tax savings.
Wait and See?
There are many ways to minimize your tax burden. One of the most popular strategies is under fire and may soon be lost. For now, take advantage of the backdoor Roth and mega-backdoor Roth conversions while you still can. Keep your mind open and your eye on alternate strategies moving forward in case the legislation does pass.
As always, RiversEdge Advisors will keep you in the know—stay tuned!