Retirement Investors: This Back Door May Be Closing for Good For HP Employees

Whether you reside in Houston or Terlingua, this article will aid you on your journey to retirement. The multitrillion-dollar legislative package being debated in Congress includes a provision that would eradicate the so-called back-door Roth IRA, a strategy that allows high-income investors to pursue tax-free retirement income. The next few months may be the final opportunity to take advantage of this possibility.

A recent report published by Forbes in March 2023 indicates that the proposed legislative package currently being debated in Congress could potentially close the back-door Roth IRA strategy permanently. If this legislation passes, high-income investors would no longer have the opportunity to make nondeductible contributions to a traditional IRA and subsequently convert them to a Roth IRA, taking advantage of the tax-free growth and withdrawals. Therefore, for HP workers nearing retirement or already retired, it becomes increasingly crucial to assess their eligibility for utilizing the back-door Roth IRA strategy before it potentially becomes unavailable.

Roth IRA Background

Since its inception in 1997, the Roth IRA has become a popular investment vehicle due to its ability to accumulate a substantial tax-free nest fund. Contributions to a Roth IRA are not tax deductible, but earnings grow tax-free as long as qualified distributions are made in the future. A qualified distribution is one made after a Roth account has been held for five years and the account holder reaches age 5912, becomes disabled, dies, or purchases a first property ($10,000 lifetime limit).

Roth IRA original proprietors are not subject to required minimum distributions at age 72, a potentially tax-beneficial benefit that makes Roth IRAs attractive for estate planning. (Recipients are subject to distribution regulations.)

However, as initially enacted, the 1997 legislation made Roth IRAs unavailable to high-income taxpayers. Individuals and couples whose income exceeded certain thresholds were ineligible to contribute to a Roth IRA or convert assets from a traditional IRA to a Roth IRA.

A Loophole Emerges

Nearly a decade after the Roth's inception, the Tax Increase Prevention and Reconciliation Act of 2005 ushered in a change that loosened the conversion rules beginning in 2010; specifically, the income limits for a Roth conversion were removed, allowing anyone to convert traditional IRA assets to a Roth IRA. (Of course, a conversion results in a tax liability on previously deducted contributions and earnings in the traditional IRA.)

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A possibly unintended consequence of this change was the emergence of a new strategy that has been used ever since: high-income individuals could make full, nondeductible annual contributions to a traditional IRA and convert those contribution dollars to a Roth. The transaction could potentially be a tax-free method for otherwise ineligible taxpayers to fund a Roth IRA if the account holders had no other IRAs (see note below) and the conversion was completed quickly enough so that no earnings could accrue. This strategy was dubbed the backdoor Roth IRA.

(Note: Before calculating a tax liability on a Roth conversion, investors must add up all of their IRAs, including SEP and SIMPLE IRAs. Suppose, for instance, that an investor has $100,000 in multiple traditional IRAs, of which 80% is attributable to tax-deductible contributions and earnings. If the investor converted any traditional IRA assets, including recent after-tax contributions, to a Roth IRA, 80% of the converted funds would be subject to taxation. This is referred to as the 'pro-rata rule.'

Current Roth IRA Income Limits

You may contribute up to $6,000 to a traditional, Roth, or combination IRA in 2021; $7,000 if you will be 50 or older by the end of the year. However, your ability to make contributions to a Roth IRA is limited or eliminated if your modified adjusted gross income (MAGI) falls within or exceeds the below-described parameters. Note that your annual contributions cannot exceed your earned income (special rules apply to Roth IRAs for spouses).

If your federal filing status is:	Your 2021 Roth IRA contribution is reduced if your MAGI is:	You can't contribute to a Roth IRA for 2021 if your MAGI is:
Single or head of household	More than $125,000 but less than $140,000	$140,000 or more
Married filing jointly or qualifying widow(er)	More than $198,000 but less than $208,000	$208,000 or more
Married filing separately	Less than $10,000	$10,000 or more

Note that your contributions generally can't exceed your earned income for the year (special rules apply to spousal Roth IRAs).

Now or Never ... Maybe

The current proposal would prohibit the conversion of nondeductible contributions from a traditional IRA after December 31, 2021, regardless of the outcome of legislative debates. If you expect your MAGI to exceed this year's thresholds and wish to fund a Roth IRA for 2021, the next few months may be your final opportunity to use the back-door strategy. Consult your financial and tax advisors for additional information.

Working with a financial professional does not guarantee improved investment performance.

You can make 2021 IRA contributions until April 15, 2022, but a Roth conversion involving nondeductible contributions must be completed by December 31, 2021, if the legislation is enacted.

Unless an exception applies, a discrete five-year rule applies to the principal amount of each Roth IRA conversion you make.

Conclusion

Imagine the back-door Roth IRA as a secret passageway to a hidden treasure chest of tax-free retirement savings. It's been a well-kept secret for years, allowing high-income investors to navigate through and enjoy the benefits of tax-free growth and withdrawals. However, the time has come when this passage may be sealed shut forever. Just like explorers who seize the opportunity to uncover hidden riches before the entrance disappears, our retirement investors must act swiftly to take advantage of the back-door strategy while it's still accessible. The closing of this back door could mark the end of a valuable pathway to secure and tax-efficient retirement savings.