Is This the end of the Backdoor Roth IRA?

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American tax planning has always been a confusing mess. On top of typical retirement savings vehicles like a 401(k) plan, you also have IRAs, Roth IRAs, Roth 401(k)’s, and all the different rules and regulations that govern how they all interact with each other.

Fortunately for the FIRE community, you have nerdy bloggers like us, Mad Fientist, and GoCurryCracker who actually enjoy unwinding all the confusing rules and figuring out strategies that allow us to use these accounts to save taxes and, more importantly, be able to access that money in order to fund our living expenses in early retirement.

Unfortunately, it looks like one of the strategies we write about may be coming to an end.

Tax-free savings in retirement are great to have at your disposal.But provisions in the Build Back Better bill would limit some of the ways to accrue them in the future — at least for high-income savers.

Congress wants to kill the ‘backdoor Roth IRA.’ Here’s what it means for you. CNN.com

The Backdoor Roth IRA

The Backdoor Roth IRA is a strategy that we’ve written about in the past, and it essentially boils down to using a loophole in the tax code to circumvent income limits on Roth IRAs.

Roth IRAs, if you’ll recall, are tax-free retirement accounts in which you can contribute after-tax money and invest it. Any income, dividends, or capital gains that accrue on your investments are not taxed, and while investment gains can’t be withdrawn until the random age of 59 1/2 without a penalty, but you can withdraw your original contributions any time you want. This is super useful for getting tax-free income in early retirement by classifying your withdrawals as principal. Hopefully by the time you run out of original contributions you will be close enough to age 59 1/2 and can access the investment gains on top of that.

While people are working and accumulating their FIRE stash, our advice is simple: Max out any retirement accounts you have access to. If your company offers a 401(k), make sure you max it out. If not, max out your Traditional IRA. And if you have any contribution room left over, max out your Roth IRA too if you can.

The problem with the Roth IRA is that if you make too much money, you can’t actually use it. Currently, if you’re married filing jointly and together make above $204,000, the amount you can contribute to a Roth IRA starts to decrease from $6000 a year down to $0 once your joint income hits $214,000.

That’s where the Backdoor Roth IRA came in.

The Backdoor Roth IRA strategy was built around the realization that although direct contributions were not allowed for people making above the income limit, conversions from traditional IRAs weren’t affected. So if you made too much money (sad trombone sound), you could get around this rule by making a non-deductible contribution to a Traditional IRA, then converting that contribution into a Roth.

The Mega Backdoor Roth IRA strategy was an even more super-charged version of that, and it relies on an employer’s 401(k) plan allowing after-tax contributions. Similar to the regular Backdoor Roth IRA strategy, you would make an after-tax, non-deductible contribution into your 401(k) plan and then do a conversion into your Roth. The big difference is that the contribution limits are way, way higher, and while a 401(k) plan allowing this is the exception rather than the rule, if you can do this you could potentially sock away $38,500 into your Roth per year.

What’s Happening in Congress?

Oh, so many things.

It can be hard to follow what’s going on in US politics since there’s just so much freaking drama all the time now, but one of the biggest legislative stories of the year was President Biden passing his whopping $1.9 trillion Build Back Better plan through the House of Representatives.

The bill itself is sprawling, affecting child care, health care, climate change, and a whole host of other Democratic priorities. Honestly, it just seems like they jammed Biden’s entire domestic agenda into one bill and shoved it through on a party line vote, which, to be honest, is what I would have done given how hard it is to get politicians to do anything these days.

However, the bill isn’t all just free unicorns and back-rubs. As part of Joe Biden’s efforts to please the progressive AOC-led wing of his party, he was forced to include provisions in the bill that would close tax loopholes for the rich, and unfortunately, the Backdoor Roth IRA got caught in the crosshairs.

Here are the new rules proposed in the bill, and, more importantly, how they impact the FIRE community

Rule #1: No more converting non-deductible contributions

Under this new rule, you would no longer be allowed to convert non-deductible contributions from a Traditional IRA into a Roth IRA. This is the most relevant rule for us FIRE folks, as converting non-deductible contributions is how the Backdoor and the Mega Backdoor Roth IRA strategies work. This restrictions would be regardless of income level, so unfortunately, if this rule goes into effect these strategies simply stop working going forward.

Rule #2: No more conversions at all above $400k income

Not only are they trying to eliminate non-deductible conversions, they also want to eliminate deductible conversions as well. This would have an even bigger on the FIRE community since it’s how we get money out of our 401(k) accounts: By building a 5-year Roth IRA conversion ladder. And if you recall, that strategy relies on converting deductible contributions from a Traditional IRA to a Roth IRA at the standard deduction level to avoid taxes.

So are we doubly screwed? Not yet. Because this rule only kicks in for anyone making over $400,000 (single filer) or $450,000 (married filing jointly) that year.

Honestly, I’m not sure who this rule is targeting, because doing a deductible conversion gets added to your taxable income, so if you were making $400k and you make a Roth IRA conversion, you would be taxed at the second-highest federal marginal rate that you can get. I supposed if you knew you’d be making even more next year and would be in the absolute highest bracket, then doing this might make sense, but that income level would need to be $523k for a single filer or $628k for a married couple. How many people are going to be in this situation?

Regardless, the income level for this rules saves the Roth conversion ladder strategy. Because you don’t actually start this process until after you retire, and obviously after you retire your income level drops, then by the time you need to do this this rule wouldn’t apply for you.

The Roth conversion ladder strategy survives! Phew.

Rule #3: No contributions and forced withdrawals for balances above $10 million

OK this one is aimed pretty squarely at the so-called fat cats, so I wouldn’t worry too much about this.

Basically, if you have a combined balance across all your tax-deferred and tax-advantaged accounts of $10 million or more and you make more than the aforementioned $400k as a single filer or $450k as a married couple, you can’t contribute to your 401(k) anymore.

In addition, you are forced to withdraw 50% of the balance over $10 million each year and take it as taxable income for.

And on top of that, if you have a balance over $20 million combined across your retirement accounts, you will be required to withdraw 100% of any balance over that threshold until your total holdings drop down below $20 million.

Again, who is this rule actually targeting? Contributions to 401(k) plans are capped at about $20k a year, so in order to accumulate $10 million, it would take $10,000,000 / $20,000 = 500 years to get there! Either these people made some insane investment gains in their account, or the majority of their 401(k) balance came from an inheritance.

Either way, this rule is unlikely to affect the FIRE community. And for the 0.00001% of the population it might effect, I’m sure those guys will figure out some weird offshore trust account scheme to get around it.

Don’t Panic Yet

So while these changes might sound alarming, we have to remember two things. First of all, this bill is still working its way through congress. Nothing is final yet.

And second of all, the Backdoor Roth IRA strategy is something that does help people get to FIRE, but it’s not something that will make or break your FIRE journey. At worst, it might add a few months to your working life because people making over $200k+ won’t be able to use the Roth to save on taxes, but again, because the max Roth IRA contribution is only $6000 a year anyway, this was a “bonus points” kind of thing rather than a critical part of our investing strategy.

The bigger impact is on people who were depending on the Mega Backdoor Roth IRA strategy to super charge their savings, but again this is a vanishingly small number of people since the 401(k) plan your employer uses has to specifically allow this in order for it to work, and most 401(k) plans don’t have this by default.

If you are in this lucky minority however, you might want to make sure you max out any contributions you can make to your Mega Backdoor Roth IRA this year, because this loophole may be closing soon and after that, you’ll just have to be like the rest of us plebes. Sorry.

Conclusion

So there you have. The government is coming for your Backdoor Roth IRA, but I think the FIRE community will survive just fine. Are you affected by this change? How do you feel about it? Are you planning on doing anything differently if these rules go into law?

Let’s hear it all in the comments below!


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17 thoughts on “Is This the end of the Backdoor Roth IRA?”

  1. I wouldn’t worry. The general sense (as of this writing) is that that BBB will collapse as a result of democrat infighting. At best, they’ll pass some half-assed bill that features hundreds of billions of dollars to provide free seniors coffee at McDonalds. Democrats know they need to pass something….ANYTHING…to get through the next election cycle.

    …for the record, if the roles were flipped, Republicans would pass an equally useless bill to get through the next election.

  2. Wanderer wrote “The bigger impact is on people who were depending on the Mega Backdoor Roth IRA strategy to super charge their savings, but again this is a vanishingly small number of people since the 401(k) plan your employer uses has to specifically allow this in order for it to work, and most 401(k) plans don’t have this by default.”

    You’re forgetting all the self-employed people working toward FIRE who receive 1099s from their clients and invest in their personal (traditional) SEP-IRA. These people can convert up to $58,000/year (depending on their income) from their tax-deferred SEP-IRA to their tax-advantaged Roth through the back door. Yes, the tax bill is hefty, but when you’re making $200,000+/year you still have plenty of money for living expenses. I converted the max from 2014-2018 and paid the taxes and now I’m retired with a comfy retirement income (much from Roth dividends) and the only federal or state tax I pay is $1200/year for FICA on book royalties. I never sat down and figured out how better off financially I’d be in the long run by holding off doing the conversions until after I retired because I wanted the peace of mind knowing I could retire with plenty of savings and not worry about conversion ladders or what Congress is doing to the tax laws. Peace of Mind = Priceless

  3. It was great while it lasted!

    BTW, that ten million dollar threshold might seem high now, but it would affect a very large number of people in a decade or two due to inflation and investment gains–not just the very wealthy.

  4. Thanks for this update. I was not aware of this change in the new bill. With this loophole possibly closing, I would be interested if you did an article comparing two scenarios for early retirement:
    – Option #1: contribute to 401k and withdraw it early and just pay the 10% penalty
    – Option #2: don’t contribute to 401k, just invest after tax

    I have not seen many people recommend #1, but this is what I plan to do. I made a spreadsheet a while back and figured out in my scenario #1 would likely be better than #2. I assumed you get the same investment return for both cases. The scenario where #1 is better is if you are making a high salary now, but plan to make much less after you early retire and have lower income tax. Also the better the investment gains you get in the 401k the better option #1 gets because of no capital gains tax. So spend after tax accounts first then the 401k to give it maximum time to grow.

    For example, I have about 40% of investments in my 401k, 60% in after tax accounts. I plan to have very little income after early retirement so income tax rate will be low. I will live on the after tax accounts first, then if those start getting low, I will switch to the 401k and pay the 10% penalty plus income tax on it.

    Maybe you have already done an article about this, but if not I would be interested in seeing if you come to the same conclusion I did, that contributing to a 401k and paying the 10% early withdraw penalty can still be better than not contributing to a 401k at all. Maybe you could show one scenario where it is better and one where it is not.

    1. If you are RE, you shouldn’t really be spending down your accounts. You should be living off the growth. If you spend more than 60% of the value of your investments before age 59 1/2, you’re likely to run out of money. Not sure about your plan…

      1. Yeah I will be living off the growth. I expect my yearly expenses to be about 5% of investments so if it grows that much plus some for inflation, I should not run out. But since it is split between 2 accounts, if I take what I need each year from the after tax account first, that may get drawn down over time while the 401k account grows to compensate. Overall though I am still living on 5% of total investments.

        My question was even if you plan to take money from a 401k early, does it still make sense to contribute to it in an early retirement scenario? I think it does, but I haven’t heard anyone recommend that. Everyone always says you can’t touch your 401k before 59.5 no matter what.

          1. Thank you that is exactly what I was looking for. I think I read that Mad Fientist article a long time ago, it seems familiar.

  5. Thank you for clarifying this! I was worried about it and couldn’t find any information explaining this from the FIRE community standpoint.

  6. With respect to Rule #1, is there any explanation of what happens if one has pre-tax and after-tax contributions mixed in their traditional IRA?

    If one is not able to convert after-tax contributions to Roth according to Rule #1, and since the existing rules say that you can’t separate pre-tax and after-tax contributions when making a Roth conversion, does that mean you won’t be able to do Roth conversions at all in this situation?

    1. I have had the same question since I first heard about this bill! Thank you for asking. I hope someone knows the answer; I haven’t been able to find anything written about it yet, nor did I see an answer in the bill itself.

  7. For the $10,000,000 retirement account cap though, isn’t it total balance, not just contributions? If it was just contributions, then yes it would take 500 years, but if you take a 25 year old with the current contribution limit of $1,666 monthly ($20k/year), say they have $50k invested already, and have their portfolio set for higher risk so they achieve a 9% return, they will have $11.5 Million at 67 years old. This is with contribution limits staying at only $20,000 and only contributing to their 401(k), not an IRA/Roth IRA as well, which would definitely bring them over the $10,000,000 mark.

    So this will effect even regular people who start investing young. IF they end up making a ton of money by the end of their career (400k/450k/year), correct? Or am I mistaken?

    I’m sure these laws will change though by 40 years from now, they’ll probably raise the limits, or the bill may not even go through. Either way, this was an interesting post. Thank you for talking about it!

  8. “Again, who is this rule actually targeting?”

    Billionaire Peter Thiel, PayPal founder, invested $2,000 in 1999 into his Roth IRA with inside information about the company.

    That investment of $2000 is now 5 billions (TAX FREE).

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