The End of Backdoor Roths

Many Americans are using a little-known tax strategy to boost their retirement savings and minimize their tax bill. The government is proposing an end to that starting January 1, 2022.

Backdoor Roth conversions have allowed many Americans to accumulate massive tax-free retirement savings. In a traditional pretax retirement accounts, such as 401k’s or IRAs, savers deduct the amount contributed from their income, thereby reducing taxes. In turn, those savers pay ordinary income tax on the amount they withdraw later in retirement. On the other hand, in a Roth account, savers contribute after-tax earnings into the account to withdraw them later tax-free.

Therefore, the backdoor Roth strategy allows savers to convert pretax savings, such as from a traditional IRA or 401k to tax-free investments with minimal tax hit. 401k conversions are available at many large companies, such as Microsoft, Amazon, General Electric, Facebook, and AT&T. Traditional IRA conversions are available on most brokerage platforms, such as Schwab and Fidelity.

In a survey conducted by record-keeper Alight Solutions LLC of 263 employer-sponsored retirement plans, 30% allowed the backdoor strategy for 401k’s. According to Fidelity, nearly 20% of their 23,500 401k plans allowed the strategy (1).

The proposal comes as an effort to prevent the wealthiest Americans from shielding millions from taxes, as well as help pay for the looming $3.5 trillion congressional bill.

The legislation proposes entirely eliminating Roth conversions of after-tax contributions from traditional individual retirement accounts starting Jan. 1, 2022. It would require most people with aggregate retirement-account balances above $10 million to take distributions, regardless of their age. It would ban holding unregistered securities, including private equity, in IRAs (2). Also, it would prohibit investments where the IRA owner is more than 10% owner in the underlying entity, or a director or officer.

Arguments against the tax-shielding strategy of Roth accounts came under intense scrutiny when ProPublica reported that Peter Thiel used his Roth account to amass a fortune of $5 billion, tax-free. ProPublica stated in their report, “It allowed everyone- including the very richest Americans – to take money they’d stowed in less favorable traditional retirement accounts and, after paying a one-time tax, shift them to a Roth where their money could grow unchecked by Uncle Same – a Bermuda-style tax haven right here in the U.S (3).

According to data requested by the Joint Committee on Taxation, aggregate IRA account balances of $5 million+ between 2014 and 2019 increased threefold. As of the 2019 tax year, more than 28,000 taxpayers had aggregate IRA account balances of $5 million or more, and 497 taxpayers had aggregate IRA account balances of $25 million or more. The average aggregate account balance for these 497 taxpayers was more than $150 million (4).

1,2) The WSJ, September 24, 2021

3) ProPublica, June 24, 2021

4) 401k Specialist, September 27, 2021