Farewell to a Friend? Congress Takes Aim at ‘Back-Door’ Roth IRAs

Farewell to a Friend? Congress Takes Aim at ‘Back-Door’ Roth IRAs

Congress is preparing to severely curtail the use of Roth IRA accounts, and I’m not entirely sure why.

The Roth IRA has long been a Congressional darling, touted as a wonderful example of cross-aisle cooperation for the good of America’s citizens.

It was the brainchild of late Senator Bill Roth, R-Del., who sold the idea of post-tax contributions and tax-free withdrawals for retirement savers to Congress. The relevant law was passed in 1997, and named in the visionary senator’s honor.

Roth IRAs are retirement accounts, where contributions come from ‘post-tax’ money – the income tax has already been paid, just like it sounds. The account appreciates tax free, and withdrawals in retirement add nothing to the senior citizen’s taxable income.

Sly savers like Roth IRAs for a less commonly voiced reason. Traditional IRAs are mirror-image products: you contribute to your account pre-tax today, then pay income tax when you take distributions in retirement. The assumption is that your future tax rate will be lower. Yet there’s a problem, often unspoken: no one really knows what future tax rates might be. This is a worry Roth IRA holders don’t shoulder: they’ve already paid up.

There is some stability in US tax rates – they rarely exceed historical bounds. Yet examine the situation today: radical ideas are afloat. American politics tend to drift to the mean, surely. But can we be sure in a “world that’s gone mad”?

That quote was heard recently from a disgruntled NY Times reporter, and whatever one thinks of her notions, she’s not the sole voice of concern. Many taxpayers, wealthier ones in particular – ever the target of tax increases – would rather pay the devil they know, today, and let tomorrow care of itself. Hence the popularity of Roth IRA and the intense concern over potential changes.

Even today, wealthier taxpayers technically cannot contribute to Roth IRAs. In 2021, the limit for single filers is $140,000; for married couples, it is $208,000. This year, the annual contribution limit is just $6,000, though if you are 50 or older this rises to $7,000.

There are ways around these income and contribution limits, legal loopholes often exploited by taxpayers, wealthy and otherwise: the so-called “back-door” and “mega-back-door” Roth IRA strategies. These are the targets of interest for Congress. While most Democratic tax proposals are limited to people earning north of $400,000, in this case, they want to lock the ‘back door’ for everyone.

Here’s what Congress is proposing as expressed by the House Ways & Means Committee. The heart of the matter: Sec. 138311, Tax Treatment of Rollovers to Roth IRAs and Accounts. I’ll skip to the last part first, then circle around; hold onto your hat:

“…this section prohibits all employee after-tax contributions in qualified plans and prohibits after-tax IRA contributions from being converted to Roth regardless of income level, effective for distributions, transfers, and contributions made after December 31, 2021.”

“Regardless of income level.” Some pundits wonder if closing a tax loophole is a stealthy tax increase on middle-class earners – something President Biden swore not to do. These new rules would apply from January 1, 2022. Bottom line, they sound the death knell on the mega-back-door Roth IRA.

If we move up the page, we find something curious. The Committee proposes ending back-door strategies by disallowing Roth conversions (for IRAs or any other employee-sponsored plan) for those whose incomes exceed the limits. You’ve probably heard of them: for single taxpayers, $400,000; for joint filing married couples, $450,000; heads of households, $425,000. Oddly, these rules would go live after December 31, 2031.

The first time I read the date, I thought it was a typo. Is it? Congress is not above clerical or editorial errors. Why would they provide so much leeway?

A lot of anxiety from these proposals stems from these varying dates, I think. Is another unpleasant surprise in store, just when we’ve planned for what we thought was the worst? (See my recent blog, ‘Mean Ways and Means – Last-Minute Taxation Changes Upend Estate Planners and Clients’ to read how this happened in the case of intentionally defective grantor trusts).

Let’s be hopeful. If the late date is correct, reflect that in politics, ten years is a long time to annul or enact. I wouldn’t panic, but retirement planners should be calling their congressmen for clarification.

What’s behind Congressional contempt for these Roth IRA strategies? Newsflow points to lurid cases of mega-million and billionaires abusing the system, stuffing gold ducats through glaringly wide loopholes into tax-free Roth IRAs.

The case of Peter Thiel, founder of PayPal, supposedly forced Congress to act, when they discovered he had $5 billion in his Roth IRA. Peter started with just $2,000, used legal trickery to balloon his balance. Basically, he contributed shares in a technically worthless, privately owned company into his account; when it went public, its value skyrocketed. Congress is shocked this could happen, likely because it nearly never does.

I call bull-nonsense. Thiel’s case is unique, not a nationwide problem. Congressional ire here is political theater, PR to sell tax increases.

Business as usual, though I concede legislators do need to find income. How much could accrue from slamming the door on these Roth IRA strategies? Maybe $4 billion over the next ten years. The US spends ten times that amount every day. Well, drip-drop in the bucket, one day it will fill up.

In the meantime, get set: back-door strategies are still legal. This suggests an urgent chinwag with your advisory team is a pressing necessity.

While you’re at it, ask them about health savings accounts, which provide tax-free appreciation of pre-tax contributions. These accounts can be used to fund qualified medical costs at any age. Post-retirement, withdrawals can be made for most any expenses, although they will be taxable, similar to a 401(k).

Talk it over with your team. They still have ways and means to buffer your tax bill, as ever within the limits of the cloudily written law.

Prosper and Live Long – With the Health to Enjoy It Mean Ways and Means – Last-Minute Taxation Changes Upend Estate Planners and Clients