What happens if Congress bans the backdoor Roth, otherwise known as the Roth two-step in 2022? Hello, my name is Paul Carroll, the CEO and founder of Avion Wealth an elite wealth management firm here in Texas. Now the Build Back Better Act is pretty much stalled, but it hasn’t gone away. And in both versions, both the House and the Senate agree on one thing. And that is the elimination of both the backdoor Roth strategy and also what’s known as the mega-backdoor Roth strategy.
So first what’s a backdoor Roth? All a backdoor Roth is, is taking advantage of different rules to put after-tax dollars into a traditional IRA, and then subsequently convert those after-tax dollars in that traditional IRA to a Roth IRA. It’s a tax-free maneuver, and it gets around the income limits for making direct contributions into the Roth IRA.
The mega-backdoor Roth is even more interesting in that if over a career you’ve accumulated both pretax and after-tax dollars in your 401k all of those after-tax dollars can be rolled over directly to a Roth IRA, as opposed to just being taken out as cash and treated subsequently as taxable investment dollars. It’s a fantastic deal. It can lead to some massive Roth IRAs, and it’s clearly not what Congress had intended when they originally developed these plans.
There are four scenarios. The first scenario is nothing happens and so there’s nothing to worry about. In the second scenario, they pass the law banning these Roth conversions effective January 1st, 2023. Again, really, that doesn’t mean anything. We just need to do it this year. The third scenario is they pass a law in the middle of the year, banning the Roth two-step immediately.
Now, if the backdoor Roth or the Roth two-steps is banned immediately, what that means is you should have already done it. Okay. So we’ve got a strategy for that. And then the fourth scenario is they ban it by passing the law this year, but they make that law retroactive to the beginning of the year. Now here’s the challenge with that: if they do that and you’ve already made your conversion, you would have to recharacterize the conversion. However, they banned re-characterization at the end of last year because they thought they would no longer be needed. How big a deal is this? Listen, if they pass this law, they’re going to probably have a technical fix. The technical fix will either be in the law, or as often is the case, it’s a subsequent bill that’s passed. The fix is all the technical errors that occur in most spending bills.
So being stuck in a Roth that you can’t recharacterize from is a very low probability event. The bigger risk is that you miss out on the opportunity because all of a sudden, the Senate decides to go along with the House and pass this bill, say in March or April and make it effective immediately. That is the single biggest risk. That’s easy. So if you have to recharacterize, don’t worry about it. That’s our problem if you’re one of our clients and we’ll take care of it. We don’t want you to miss out on the opportunity. Much greater risk is that we drag our feet, they change the law and now you can’t do it. It’s a risk for Roth IRAs. It’s a massive risk for after-tax dollars in 401ks if this is the year you’re planning on retiring, or at least rolling that 401k out. If you need any assistance, be sure to give me a call. We wish you the best of investing success this year. Thank you.
Scott, Michelle P. “The Build Back Better Act Would Greatly Limit Backdoor Roth Conversions.” Investopedia, Investopedia, 4 Jan. 2022, https://www.investopedia.com/threat-to-mega-backdoor-roth-conversions-5211038.
Paul is the founder and CEO of Avion Wealth, LLC. He leads a team of wealth managers in building and executing financial plans for high net worth individuals and families. Contact Avion Wealth to speak with a financial advisor.
