One piece of the Build Back Better bill, which the Senate failed to pass in late 2021, was closing a loophole referred to as the backdoor Roth IRA. The backdoor Roth allows individuals earning more than the income limits for direct contributions to a Roth IRA to effectively make those contributions by taking an extra step. Getting those savings into a Roth IRA can be a nice way for high-income households to protect a bigger portion of their investments from taxes.
After failing to pass the legislation, Congress will likely take a look at it again and try to pass it in 2022. So, if you want to take advantage of the backdoor Roth IRA, you should do it now.
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How the backdoor Roth IRA works
The backdoor Roth IRA takes advantage of the ability to make after-tax contributions to a traditional IRA. Once those funds are in the IRA, you can perform a Roth conversion. But since you've already paid taxes on the contribution, you won't pay taxes again when you convert the funds to a Roth account.
Likewise, you may be able to contribute after-tax dollars to your 401(k) plan and then take in-service withdrawals and convert them to a Roth IRA. That maneuver is called the mega backdoor Roth. It allows savers to contribute up to the maximum $61,000 in a 401(k) and maximize the tax protections on all of those savings.
The Build Back Better plan, as it was written last year, would ban the Roth conversion of after-tax funds in a traditional retirement account. But since the bill failed to pass the Senate, the option to convert after-tax contributions is still there.
Don't wait
It won't pay to procrastinate. If the Senate revisits Build Back Better in 2022 and passes a version of the bill banning the backdoor Roth, it could take effect immediately. It's possible, but unlikely, that it could retroactively impose the restrictions dating back to the start of the year. It's also possible it doesn't put them into effect until the start of 2023.
In any case, the downside of executing the backdoor Roth early in 2022 is significantly smaller than the potential gain from doing so. The downside is the possibility you'll need to unwind a conversion, and you'll end up with after-tax funds in your IRA or 401(k). While it's not ideal, it's far from a major loss, and I believe the odds of being forced to pull money back out of your Roth IRA are very small. Meanwhile, the upside is another year of adding money to your Roth IRA.
In other words, you're unlikely to regret making a backdoor Roth conversion early in 2022. If you have the funds available right now and believe you'll be above the income thresholds for Roth contributions in 2022, consider performing the backdoor Roth now. That said, if the idea of having to unwind a conversion and end up with after-tax funds in your account is untenable, you should wait until there's more clarity on the situation.
If you have a 401(k) plan that enables the mega backdoor Roth, you could talk to your plan administrator about prioritizing after-tax contributions and Roth conversions. You can move to traditional pre-tax contributions later in the year. This move carries a bit more risk. If you lose your job midyear, you may miss out on the opportunity to make those tax-deductible contributions later in the year.
Maximizing your balances in tax-advantaged accounts is one of the best ways to speed up your path to retirement. If the backdoor Roth IRA is an important part of your retirement planning, don't wait on it in 2022.
