The Build Back Better Act passed by the House on November 19, 2021, eliminates taxpayers’ ability to make “back door” Roth IRA contributions, effective for tax years beginning after December 31, 2021. The bill has moved to the Senate where changes could be made before it is passed. However, if the legislation is passed without changes, this strategy to fund a Roth IRA must be executed prior to December 31.
Roth IRAs and Roth 401(k)s are attractive for many reasons. While there are no current tax deductions for contributions to Roth accounts, the contributions grow tax-free throughout your lifetime. When the funds are withdrawn, the original contributions and all of the accumulated income will be tax-free.
You must meet the five-year rule in order for the earnings to be tax free. This means that you must wait five years after your first contribution to withdraw earnings without paying tax on them. The five-year period starts the first day of the tax year in which you made your first contribution to the Roth. In addition, there are no required minimum distributions (RMD), and accounts can be passed to beneficiaries with no tax consequences.
The ability to contribute to a Roth IRA is limited for high earners. If you are a single filer, the ability to contribute begins to phase-out when modified adjusted gross income exceeds $125,000. If you are married, filing jointly, the phase-out starts at $198,000 for 2021.
If your income is above these phase-out levels, an alternative strategy is to make a non-deductible contribution to a traditional IRA and then convert it to a Roth IRA. However, that can have tax consequences if you have other traditional IRAs where you have received deductions for your contributions. The rules require that any amount converted to a Roth from a traditional IRA must be prorated between the nondeductible balance and the balance in the IRA accounts where deductions were received. In this scenario, most of the conversion is taxed in the year of conversion, but future growth and distributions will receive full benefit of the Roth structure.
The maximum contribution to both traditional and Roth IRAs for calendar year 2021 is $6,000. This is increased to $7,000 for those aged 50 and older.
The SECURE Act, passed in December 2019, provided a new way for savers to put larger amounts of money away for tax-free growth. Many 401(k) plans allow three types of contributions by an employee:
- Pre-tax contributions that are tax-deferred (traditional 401(k) contributions);
- Roth contributions, which are made with after-tax dollars but grow tax-free; and
- After-tax contributions for which earnings are tax-deferred.
An after-tax Mega Roth lets taxpayers rollover an after-tax contribution of up to $39,000 from an employee 401(k) plan into a Roth IRA or Roth 401(k) in 2021. This is a great way to catch up on Roth savings, and many employers have added a Mega Roth option to their 401K plan offerings for their employees.
Here’s how it works:
The limit on Mega Roth contributions to a 401(k) plan is $58,000 ($64,500 if age 50 or over) for 2021. This includes employee contributions, employer contributions (such as matching contributions) and after-tax contributions.
If an employer does not make a matching contribution on an employee’s behalf, a 401(k) plan participant may have the option of making an additional contribution of up to $39,000 to their 401(k) plan as an after-tax contribution. If the employer plan allows it, under IRS Revenue Notice 2014-54, this after-tax contribution may be rolled into a Roth IRA outside of the 401(k) plan.
The optimum timing to roll an after-tax contribution into a Roth IRA is immediately after the 401(k) contribution is made, prior to accumulating any taxable earnings. If the conversion amount contains anything other than your after-tax contributions, you would pay tax on that portion.
For example, if a plan participant over age 50 made a $25,500 deferral contribution to their 401(k) and an additional $39,000 after-tax contribution ($64,5000 in total), and the plan allowed an in-service withdrawal, they could roll that after-tax contribution into a Roth right after the contribution was made. Most plans allow in-service withdrawal at age 59 ½ or older.
The Mega “back door” Roth is not for everyone, but if you are interested in pursuing this option, check your employer’s 401(k) plan to see if it offers the Mega Roth option and in-service withdrawals.
Contact Marcum tax advisor for additional information and assistance.
