What to Do If Democrats Ax the Backdoor Roth Individual Retirement Account Strategy

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  • To help fund their multitrillion-dollar budget plan, House Democrats have called for ending the "backdoor" and "mega-backdoor" Roth individual retirement account strategies.
  • Financial advisors are weighing plans with clients as the after-tax backdoor maneuver may disappear after Dec. 31.
  • However, the proposals are still in flux as Democrats wrestle over the final package.

A couple of popular retirement savings techniques may soon be disappearing as Democrats hash out how to pay for their multitrillion-dollar spending package.

Advisors are already exploring solutions for their clients.   

Currently, investors with a modified adjusted gross income for 2021 above $140,000, or $208,000 for couples filing jointly, can't contribute to a Roth individual retirement account. 

But wealthier investors can skirt the limits with a so-called backdoor maneuver by making what's known as nondeductible contributions to their traditional IRA and then quickly converting the money to their Roth IRA. 

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The "mega-backdoor" Roth strategy can be even more powerful, allowing someone to convert more funds with after-tax 401(k) contributions.  

House Democrats, however, want to crack down on both, regardless of income level, after Dec. 31, according to a summary released by the House Ways and Means Committee.

Pretax conversions — using funds that levies haven't been paid on — are still allowed in the proposed legislation. But those with taxable income of more than $400,000, or $450,000 for married couples filing together, wouldn't be able to use the strategy just over a decade from now, after Dec. 31, 2031. 

As the debate heats up in Congress, financial advisors are still watching for the final details.

In the meantime, here are some possible solutions they are weighing with clients. 

"We're still recommending backdoor Roth IRA contributions and making mega-backdoor Roth 401(k) for 2021," said certified financial planner Brian Schmehil, director of wealth management at The Mather Group in Chicago. 

Someone eyeing these moves should start weighing the pros and cons with a financial advisor before the year-end deadline. 

While the Democrats' proposal applies to conversions after 2021, employees may still have the option to transfer after-tax 401(k) contributions to a Roth IRA when they retire and roll over their funds, Schmehil said.

"It appears that the proposal would not impact the current ability to take your after-tax 401(k) contributions and move them to a Roth IRA when you separate from service," he said.

Additionally, more employers may add Roth 401(k) options to company plans, which all investors regardless of income may still use, Schmehil said.

Health savings accounts

If Democrats pull the plug on backdoor and mega-backdoor Roth IRA strategies, eligible investors may prioritize health savings account contributions. 

"People are still going to look for ways to grow money tax-free," said Ashton Lawrence, a CFP with Goldfinch Wealth Management in Greenville, South Carolina.

Investors with eligible high-deductible health insurance may write off 2021 contributions of up to $3,600 for individual or $7,200 for family plans. They can grow the money tax-free and withdraw the funds penalty-free anytime for qualified medical expenses. 

However, many people don't realize they can use the money "essentially for anything" once they're age 65, said Lawrence. While there is no penalty on the withdrawal after age 65, investors will still pay income taxes.

"Once you have assets in there, there isn't a required minimum distribution, like a traditional IRA, either," he added.

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