Backdoor Roth IRA
/Among the many provisions in the trillion-dollar-plus legislative package being debated in Congress is a provision to eliminate a strategy called the backdoor Roth IRA conversion. If passed, this may be the last year for high-income investors to pursue tax-free growth on their retirement income using this strategy.
Since its inception in 1997, the Roth IRA has been an attractive vehicle to build a tax-free nest egg. Although contributions to a Roth IRA are not tax deductible, any earnings in the account grow tax-free if future distributions fall under specific qualified guidelines. Due to income thresholds, high-income taxpayers were not able to participate in contributions nor conversion of traditional IRA assets to a Roth.
Nearly 10 years later, legislation ushered in a change that relaxed the conversion rule income thresholds. One outcome was the emergence of a new strategy utilized ever since: High-income individuals could make full, annual, nondeductible contributions to a traditional IRA and convert those contribution dollars to a Roth.
If the account holder had no other IRAs and the conversion was executed quickly enough, there would be no earnings accrued to be taxed. Then the Roth account could grow tax-free. However, if the account holder has deductible IRA contributions in any account, the tax on the conversion is pro-rated accordingly.
For 2021, you may contribute up to $6,000 to an IRA (traditional, Roth, or in combination); $7,000 if you will be age 50 or older by December 31. While there are no income limits to contribute to a traditional IRA, contributions to a traditional IRA are subject to annual income thresholds for deducibility purposes. Your ability to make contributions to a Roth IRA is limited or eliminated if your income exceeds the annual parameters.
While you may make contributions until April 15, 2022, it may be the end of the year before we know what may come of the legislative debates. If passed, the current proposal would prohibit the conversion of nondeductible contributions from a traditional IRA after December 31, 2021. Therefore, the next few months may be your last chance to use the backdoor strategy.
- Pam Smitson, CPA, CGMA, Smitson Erhart-Graves Financial Advisors
