Backdoor Roth IRA: Will it Stay, or Will it Go?

Key Takeaways:

• Before establishing a backdoor Roth IRA, investors should consider their comfort with leaving money in the account for at least five years.

• Investors looking to withdraw their money within five years may not receive all their tax benefits.

• A retooled Build Back Better Act could be retroactive, impacting backdoor conversions.

The backdoor Roth individual retirement account (IRA) is popular among those with high incomes as a way to contribute to a Roth IRA despite its income limits.

However, if President Biden’s Build Back Better (BBB) Act ultimately passes and nixes the “backdoor” strategy, high-value investors may have to reassess that aspect of their retirement planning. To maximize tax savings, they also may want to explore alternative investment options.

What is the Backdoor Roth IRA Strategy?

After the Internal Revenue Service removed income caps on Roth IRA conversions some 13 years ago, many people with high incomes began taking advantage of a loophole known as the backdoor Roth. The strategy, which allows investors to convert after-tax money to Roth IRAs for which they would otherwise be ineligible, calls for contributing to a traditional IRA before converting it to a Roth.

President Biden’s Build Back Better Act contains provisions that would eliminate the backdoor loophole, but the legislation has so far stalled. That could change.

Status of the Backdoor Roth IRA

Biden’s BBB Act was introduced in 2021 and subsequently passed by the House. Since then, however, it has languished in the Senate. A watered-down version, dubbed by some as “BBB lite,” was passed into law last August as the Inflation Reduction Act of 2022.

However, there is always a chance a retooled Build Back Better Act will be back on the table. And importantly, it could be retroactive, affecting backdoor conversions that have already taken place.

As it stands, legislative planks would have eliminated backdoor Roth contributions beginning this year. They would also prohibit Roth conversions for high-income investors beginning in 2032.

Specific Propositions in Build Back Better

Pertinent BBB Act provisions include:

• Restrictions on IRA contributions for high-income earners. Once accounts exceed $10 million, further contributions would be prohibited.
• End of after-tax rollovers to Roth IRA. For all income levels, after-tax contributions to employer plans and IRAs cannot be converted to Roth savings.
• Exclusion of high-income earners from Roth conversions. Backdoor Roth IRA conversions would be prohibited for single individuals earning more than $400,000 — $450,000 for married couples.
• Required minimum distributions for high-income earners. There would be required minimum distributions for retirement accounts of $10 million. Such investors would be required to withdraw half the amount above $10 million, beginning on Dec. 31, 2028.

History and Mechanics of Roth IRA Conversion

Before 2010, rollovers from another type of IRA or retirement plan were only allowed if one’s modified adjusted gross income was under $100,000 and their filing status was anything other than married, filing separately. After such restrictions were eliminated, that led to backdoor access to a Roth retirement account.

Roth IRAs have been particularly attractive to wealthy investors. After all, after age 59.5, the investor can take advantage of tax-free withdrawal and investment growth, and unlike traditional pre-tax-accounts, there are no required withdrawals at age 72. There are also no required minimum distributions, and investors can bequeath their qualified distributions tax-free to a beneficiary. Further, investors may continue to make contributions after age 70.5.

The rub is that there are income caps on Roth IRA contributions. In 2023, single individuals cannot save in one if they earn more than $153,000 annually. But so far, high-income people can still save in a Roth IRA using “backdoor” contributions.

How a Backdoor Roth IRA is Set Up

There are a couple of ways to establish a backdoor Roth IRA. Before doing so, investors should factor in their willingness to leave money in a Roth for at least five years. Investors looking to withdraw their money within that time frame may not receive all the tax benefits.

Contribute to an IRA, then roll the money over to a Roth IRA

If this strategy is to be effective, investors should contribute to a traditional Individual Retirement Account with zero balance. Otherwise, their conversion could be taxed. Following account contribution and any necessary holding period, the account can be converted to a Roth IRA.

Note that if market performance resulted in earnings before the conversion transpired, those earnings are taxable. Also, there is no tax advantage for the year a backdoor Roth IRA is established.

Do a Mega Backdoor Roth Conversion

Some 401(k) plans allow automatic Roth conversions. This means that after-tax contributions can be made and be automatically converted to Roth. Investors should see whether they have this option with their plan.

When to Avoid the Backdoor Roth IRA Strategy

A backdoor Roth IRA is not right for everyone. For instance, an investor may not want to set up one if they have a balance in a rollover IRA and intend to contribute to it. That is because of the “pro rata” rule that requires all IRA distributions to be proportionally extracted from pre- and after-tax contribution sources. That might affect the tax advantages received through a Roth conversion.

Say an investor has $1 million in IRA assets, and 10% is after-tax money. That means that 10% of any withdrawal must come from after-tax funds — $1,000, in this case.

Yieldstreet IRA

While not a self-directed IRA, the investment platform Yieldstreet offers a private market IRA that allows investors to add alternatives to their retirement portfolio. Essentially any assets other than stocks and bonds, alternatives are not directly tied to public markets, and so are much less affected by volatility. Art, real estate, and collectibles are examples of alternative investments.

In the past, adding alternatives to IRAs was complicated and costly fee-wise. With Yieldstreet’s offering, diversification merely requires investing in a taxable account. Most investments across Yieldstreet’s 10 asset classes are eligible for an IRA, and the platform reserves curated high-demand investment opportunities for IRA investors. Also, Yieldstreet offers electronic fund transfers from most major IRA and 401(k) providers.

Alternative Investments and Portfolio Diversification

Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. However, that meant the potentially exceptional gains these investments presented were also limited to these groups.

To democratize these opportunities, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments.

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10000.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary

The backdoor Roth IRA strategy is still legal – for now. There are rumblings in Washington about addressing it again, so it might be a smart move to reevaluate retirement planning. Investors also might want to consider alternatives to get as much tax savings as possible. It’s a good idea to go over options with a financial advisor or accountant.

All securities involve risk and may result in significant losses. Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.