Backdoor Roth 401(k) and IRA rules for the wealthy survive — for now

The “backdoor Roth” tax strategy used largely by wealthy retirement savers and slated to be killed next year has survived — for now.

The loophole lets rich 401(k) and individual retirement account owners save in a Roth-style account, shielding future investment growth from tax. Roth accounts are generally off-limits to such investors due to an income cap.

Democrats aimed to end the rules starting in 2022 as part of the Build Back Better Act, a roughly $1.75 trillion package of climate and social investments coupled with changes to the tax code aimed at rich Americans.

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House Democrats passed the legislation in November; Senate Democrats hoped to pass it by year’s end. But Sen. Joe Manchin, D-W. Va., scuttled those plans on Sunday, announcing that he won’t back the measure in its current form. Manchin’s vote is crucial to pass the bill due to unified Republican opposition.

The delay means the prohibition on the backdoor Roth strategy won’t kick in at the beginning of 2022 as planned — meaning taxpayers may not have to scramble to take advantage of the rules before they’re outlawed.

If Democrats pass the legislation early next year, it’s likely (though not certain) that Congress would postpone the effective date to 2023, experts said.

“I don’t think you’re going to have an effective date in the middle of the year,” said Steven Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center. “That’s too cumbersome.”

“You might have thought you should be racing to get a backdoor Roth in place,” Rosenthal said. “But you don’t need to race.”

The backdoor Roth rules were among the few targeting wealthy retirement savers that would have begun next year. Others, like one creating new distribution rules for retirement savings exceeding $10 million, would have started later in the decade.

The prohibition on backdoor Roth contributions would affect all taxpayers, unlike most other aspects of Democrats’ tax proposals, which impact households with $400,000 or more of income.

Roth accounts are especially attractive to wealthy investors. Investment growth and future withdrawals are tax-free after age 59½, and there aren’t required withdrawals at age 72 as with traditional pre-tax accounts.

However, there are income limits to contribute to Roth IRAs. In 2021, single taxpayers can’t save in one if their income exceeds $140,000. (The cap is $208,000 for married couples filing a joint tax return.)

High-income individuals can skirt the income limits via a “backdoor” contribution. Investors who save in a traditional, pre-tax IRA can convert that money to Roth; they pay tax on the conversion, but shield earnings from future tax.

(There isn’t an income limit for contributions to pre-tax IRAs. However, wealthy taxpayers likely can’t deduct that contribution from their taxes, as lower earners can.)

Workplace retirement plans (like a 401(k) plan) don’t prohibit wealthy investors from Roth savings. But another loophole — the “mega backdoor Roth” strategy — lets them invest large sums of money well above the typical annual contribution limits in 401(k)s and IRAs.

This process involves making an after-tax contribution to a 401(k) and converting that savings to a Roth-style 401(k) or IRA account.

IRA and 401(k) rules disallow more than $6,000 and $19,500 of annual contributions in 2021, respectively. (Those limits are higher — $7,000 and $26,000, respectively — for those age 50 and older.)

However, some employers permit savers to invest tens of thousands of additional funds via after-tax contributions courtesy of other tax rules.

In 2021, employees could save an additional $38,500 in a 401(k) plan via after-tax contributions, which may then be converted to Roth funds. (It’s $45,000 for those age 50 and older.)

Most employers don’t allow for such contributions, though. Roughly 20% of 401(k) plans did so in 2020, according to the Plan Sponsor Council of America. The share is nearly double that when examining just the largest companies, with over 5,000 employees participating in the plan.