The budget reconciliation proposal (also known as Build Back Better) included provisions that would have killed the backdoor Roth planning technique, but when the White House agreed to a more limited version of the bill with lower costs, those provisions were removed, but the relief was only temporary. As the House of Representatives worked on the new version of the budget reconciliation act, most of the stripped Roth provisions were added back into the legislation, but with some changes to the effective dates. 

This article walks through the initial proposal and explains which provisions are in the bill now, and what the proposed effective dates are.

Backdoor Roth Conversions

Under current law, contributions to Roth IRAs have income limitations. For example, for 2021, single taxpayers with income above $140,000 are not permitted to make Roth IRA contributions.

However, that limitation doesn’t apply to Roth conversions. For example, if a person exceeds the income limitation for contributions to a Roth IRA, he or she can make a nondeductible contribution to a traditional IRA, then shortly thereafter convert the nondeductible contribution from the traditional IRA to a Roth IRA.

As a general premise, tax laws don’t allow taxpayers to do indirectly that which they cannot do directly (or, stated differently, if you can’t go in through the front door, then usually you can’t go in through the back door either). However, that is not the case with Roth IRA conversions.

Tax laws don’t allow taxpayers to do indirectly that which they cannot do directly. However, that is not the case with Roth IRA conversions.

The initial budget reconciliation proposal would have prohibited after-tax contributions by participants in qualified plans, as well as after-tax IRA contributions by individuals, from being converted to Roth accounts regardless of income level, effective for distributions, transfers, and contributions made after December 31, 2021.

However, that provision was taken out in the White House version. But it was reinstated in the current House of Representatives version with the same effective date. As a result, if financial professionals are considering advising their clients to use this backdoor Roth technique with either plan or IRA after-tax contributions, it should be done this year, because it’s possible, or even probable, that it won’t be available next year.

In an effort to completely close these so-called “backdoor” Roth IRA strategies, the first version of the bill also would have eliminated pre-tax Roth conversions for both IRAs and employer-sponsored plans for single taxpayers (or taxpayers married filing separately) with taxable income over $400,000, married taxpayers filing jointly with taxable income over $450,000, and heads of households with taxable income over $425,000 (all indexed for inflation). This provision would have applied to distributions, transfers, and contributions made in taxable years beginning after December 31, 2031.

Again, the White House dropped this provision from its version of the budget reconciliation bill. However, this provision, with the same effective date, was reinstated by the House of Representatives.

Commentary: A quick reading of these descriptions of the bill’s provisions could be confusing. The first is effective almost immediately: after December 31, 2021. The effective date for the second provision is 10 years later: after December 31, 2031.

This raises two questions: What are the differences in these provisions? Why are there different effective dates?

In the first case, the provision applies only to the conversion of after-tax, non-Roth accounts. For example, it applies where a taxpayer has high enough income that the taxpayer couldn’t directly make a Roth IRA contribution; in that case, the taxpayer can make an after-tax IRA contribution. In the right circumstances, the IRA investor could then convert the after-tax contribution to a Roth IRA and only pay additional taxes on any gains or income between the date of the contribution and the time of the conversion—probably a minimal amount. Thereafter, the IRA is just a Roth IRA. (There are complex issues for these conversions, particularly if a taxpayer has other pre-tax IRAs, but that’s beyond the scope of this article.) This arrangement is commonly referred to as a “backdoor Roth IRA.”

Similarly, a participant under age 50 in a 401(k) plan that permits nondeductible contributions can make a regular deferral of $19,500 in 2021. (If a participant is over 50, he or she can contribute an additional catch-up amount of $6,500.) If the employer matches at 50% on the regular deferrals, that’s another $9,750, for a total of $29,250—against a maximum limit of $58,000 for 2021. This leaves another $28,750 that the participant could contribute as an after-tax amount. If the plan permits Roth conversions within the plan, the 401(k) account with the $28,750 of nondeductible contributions could be converted to a Roth account with little, if any, additional tax consequences. As with Roth IRA conversions, any income earned after the after-tax conversions were made, but before the conversion, would be taxed to the participant. (This arrangement doesn’t work for all plans since it’s subject to nondiscrimination testing.) This is the so-called “mega backdoor Roth.”

Under current law, taxpayers may make contributions to IRAs regardless of how much they’ve saved in their accounts.

The current version of the budget reconciliation bill would end both of these after-tax Roth conversion techniques after December 31.

However, the second provision—the one that will be effective after 2031—doesn’t apply to all taxpayers. Instead, it only applies to higher earners (which the bill defines as single taxpayers and taxpayers married filing separately with taxable income over $400,000, married taxpayers filing jointly with taxable income over $450,000, and heads of households with taxable income over $425,000—all indexed for inflation). This provision would prohibit Roth conversions of pre-tax amounts (as opposed to after-tax amounts in the first provision)—for both IRAs and plans. 

Why wouldn’t the provision for Roth conversion of pre-tax contributions have applied until years after December 31, 2031? 

That’s because, under its arcane system, Congress gets to count this as a revenue raiser. The assumption is that many IRA owners and plan participants would be converting their accounts from taxable to Roth during the 10-year window, resulting in more income taxes being collected by the government. And, since budgeting for legislation is calculated on a 10-year time frame, the savings that the Roth account owners would have gotten when they take their money out tax-free after the 10-year period doesn’t count as a tax loss. 

Other Roth Provisions 

Limits on IRA Investments

The initial version of the bill would have prohibited an IRA from holding any security if the issuer of the security requires the IRA owner to have certain minimum level of assets or income; requires a minimum level of education; or requires a specific license or credential. For example, the legislation would have prohibited IRAs from holding investments that are offered only to accredited investors, because those investments are securities that haven’t been registered under federal securities laws. IRAs holding those types of investments would have lost their IRA status. 

This section was intended to take effect for tax years beginning after December 31, 2021. But there was a two-year transition period for IRAs already holding these types of investments.

However, this provision was dropped from the White House version and has not been reinstated in the new House of Representatives’ bill.

Commentary: As background, the concern was that wealthy taxpayers have used Roth IRAs to acquire investments not generally available to others, e.g., not available to middle-class taxpayers. There is also a concern that those investments may have been acquired at favorable prices, perhaps overly favorable prices. For a better understanding of this concern, Google “Peter Thiel billion dollar Roth IRA.”

There is at least a chance that there will be a similar proposal in the future—but probably not this year. Several influential members of Congress are concerned that IRAs are being “abused” by wealthy investors; those members see IRAs (and particularly Roth IRAs) as retirement vehicles for “main street” taxpayers and not as a tax-sheltered investment vehicle for the wealthy.

Two required minimum distribution (RMD) changes will require the unwinding of tax-preferred savings, and some of the investments in those accounts, by forcing money out of IRAs and defined- contribution plans.

Contribution Limit for IRAs of “High-Income” Taxpayers 

Under current law, taxpayers may make contributions to IRAs regardless of how much they’ve saved in their accounts. To eliminate the possibility of subsidizing retirement savings once account balances reach very high levels, the initial version of the legislation would have created new rules for taxpayers with very large IRAs and defined-contribution retirement accounts. Specifically, the proposal would have prohibited further contributions to a Roth or traditional IRA for a taxable year:  

• (1) if the total value of an individual’s IRAs and defined contribution retirement accounts exceed $10 million as of the end of the prior taxable year, and 
  
  
• (2) if a single taxpayer (or taxpayer married filing separately) has taxable income over $400,000, a married taxpayer filing jointly has taxable income over $450,000, or a head of household has taxable income over $425,000 (all indexed for inflation). 

This provision would have been effective almost immediately for tax years beginning after December 31, 2021. 

Again, the White House removed this provision, but the House of Representatives has added it back into the bill, but with a later effective date for tax years beginning after December 31, 2028. As a result, high-income, wealthy taxpayers can continue to make IRA contributions until then (assuming that they otherwise qualify).

Increase in Required Minimum Distributions for Large Account Balances

If an individual’s combined traditional IRA, Roth IRA, and defined-contribution retirement account balances exceed $10 million at the end of a taxable year, the initial proposal and the current version of the bill would require that a minimum distribution be made in the following year. This minimum distribution is only required if the taxpayer’s modified adjusted gross income is above the thresholds described above (e.g., $450,000 for a joint return). The minimum distribution generally is 50% of the amount by which the individual’s prior year aggregate traditional IRA, Roth IRA, and defined-contribution account balance exceeds the $10-million limit. For example, if the individual’s combined balances at the end of the year totaled $12 million, the individual’s minimum distribution would be $1 million (one half of the $2 million excess over $10 million). 

In addition, if the combined balances in traditional IRAs, Roth IRAs, and defined-contribution plans exceeds $20 million, the excess would be required to be distributed from Roth IRAs and Roth-designated accounts in defined-contribution plans up to the lesser of (1) the amount needed to bring the total balance in all accounts down to $20 million, or (2) the aggregate balance in the Roth IRAs and designated Roth accounts in defined-contribution plans. 

Once the individual distributes the amount of any excess required under this 100% distribution rule, the individual must comply with the $10-million distribution rule discussed above. The individual is allowed to determine which accounts the distributions will be taking from to satisfy the $10 million/50% distribution rule. 

If it had stayed in the bill, this provision would have been effective for tax years beginning after December 31, 2021. However, when the House of Representatives reinstated this provision, it changed the effective date to tax years after December 31, 2028, which delays the requirements by another seven years. That allows more time for financial professionals to work with their clients to minimize the impact of this likely change.

Commentary: While the provisions in the first part of this article would limit the availability of tax preferences, these two required minimum distribution (RMD) changes will require the unwinding of tax-preferred savings, and some of the investments in those accounts, by forcing money out of IRAs and defined-contribution plans. An unspoken policy statement is that defined-benefit plans (which includes cash-balance plans) are “preferred” in the sense that they aren’t included in these proposals. As a result, financial professionals may want to consider recommending cash balance or pension plans to their clients whose circumstances allow for that.

Concluding Thoughts

While the outcome for this legislation is not certain, there is a least a strong possibility, or even a probability that the bill will pass with these Roth provisions. In that case, the tax landscape for Roth conversions, Roth investment opportunities, and large-account holders could change dramatically. Financial professionals should understand these possible changes and be prepared to help their clients navigate the opportunities available this year; the opportunities that remain due to the delayed effective dates of some provisions; and the potential changes to RMDs and their impact.