Just like you, I’ve seen more and more articles on Roth conversions using terms like “Backdoor Roths” or “Mega Roths”. The concept is neither new nor until recently particularly controversial. What has changed are reports that several wealthy individuals have invested in their Roth IRA stocks from start-ups that have grown rapidly in value – and are now expected to produce tens of millions of dollars or more that will not be taxable when finally distributed. This probably won’t be the situation for most of your clients – but headlines will, and perhaps already are, arouse interest.
Why it matters
Individuals who expect to pay higher tax rates in the future may now want to pay tax on their savings before taxes (and earnings) – and may want flexibility to avoid forced distribution (and taxation) of the required minimum distributions. (Roths are not subject to this.)
The thing that makes Roth contributions unique is that they are paid in dollars after tax, but once held in that account (subject to certain restrictions[i]), earnings that are accumulated are not subject to taxation, as well as contributions (which are realized with money after taxation). Note that, although there are revenue limits that can make Roth a contribution to the IRA, they do not apply to Roth 401 (k) or Roth 403 (b) accounts. However, the plan must allow Roth’s contributions (and not all).
Pre-tax conversions of IRAs to Roth IRAs are allowed, although the full amount would be taxable in the converted year. Many employers ’plans also allow for conversion, but again, it depends on the terms of the plan.
Contributions to MEGA or Backdoor Roth
In a qualifying post-tax contribution plan (this must again be a provision in the plan), the participant can contribute to the difference between the total contribution limit ($ 58,000 for 2021 or $ 64,500 for those participants over the age of 50). For example, if a 45-year-old participant defers $ 19,500 and receives $ 19,500 per match (and has no other employer contributions or foreclosures) decides to fund post-tax contributions, it can do so up to $ 19,000 ($ 58,000 – $ 19,500 – $ 19,500) . Then, if the plan allows Roth conversions, they can cover that amount in Roth. If the plan does not allow Roth conversion, the participant can take the distribution and transfer it to the Roth IRA.
So, what could be wrong?
It is often forgotten that working with retirement plans is never so easy. Here are a few items to consider:
- Roth contributions or conversions are taxed in the year in which they are invested or converted. This can be quite a shock at check-in time if there is no retention or amount planning.
- Each Roth conversion has a separate five-year tracking period to be a qualified distribution, so this can be a challenge when keeping track of amounts. Basically, you will now pay taxes, but you will need to wait five years from the conversion to convert to Roth. If you undertake an apportionment of amounts before qualifying for a non-taxable apportionment, then earnings will be taxable and may be subject to an additional 10% tax under Section 72
- Post-tax contributions for a qualified plan such as 401 (k) are subject to the ACP non-discrimination test (even in a safe harbor plan). Therefore, a highly compensated individual who thinks he is using a strategy may find that the conversion fails that test and must return the money.
- We recently received a question about a test that failed but was launched after the amount was distributed and transferred to the Roth IRA. In that case, the transfer would be unacceptable and would have to be removed from the account. (Personally, this is not a conversation I would like to have with a participant.)
- Of course, if an individual’s tax rate is shown below in the future, then the tax benefit of this strategy will be lost.
Is it worth it?
In short, a Roth strategy may suit you and your customers – but make sure they are aware – or beware – of all potential tax implications.
Robert M. Kaplan, CFP, CPC, QPA, QKC, QKA, is director of technical education at the American Retirement Association.
[i] The conditions are that the account is open for five calendar years, and the distribution is after the age of 59 or the death or disability of the account holder.