Mega and Backdoor Roth Contributions: Do You Feel Lucky?

Mega and Backdoor Roth Contributions: Do You Feel Lucky?

Often politicians pass laws that have unintended consequences, making tax planning difficult. This year the uncertainty revolves around two methods to build up your tax-free savings that may go away if the Biden administration’s Build Back Better legislation passes. I’ll describe the situation and the three possible outcomes.

As background, some workers have the ability to maximize their savings through their company 401(k) account. If their plan allows it they can make additional non-deductible salary deferrals – often referred to as “mega-Roth” contributions – of up to $67,500 annually (depending on age, salary deferral amount, and company contribution amount) into a third portion of their account. These contributions are not tax-deductible but can be rolled over to a Roth account and will grow tax-free for life. 401(k) plans without this feature limit participant salary deferrals to $20,500 ($27,000 if age 50 or older).

Another way to grow tax-free savings is to contribute to a Roth account. Unfortunately the IRS disallows Roth contributions if your AGI is greater than $214K for married couples or $129K if you’re single. The way around this is via what is known as a “backdoor” Roth. In effect you contribute the money to an empty IRA account instead (there are no AGI limits to IRA contributions) and then do a Roth conversion to move the cash to the Roth. This strategy avoids taxation on the conversion when you have no other funds in the IRA and also works because there’s no AGI limit for Roth conversions as there is for Roth contributions.

If the Build Back Better legislation passes you may need to undo any contributions you made. That’s not a problem with the backdoor Roth (although it can be a bit complicated). But there’s no legal way to withdraw a contribution from a 401(k). This results in three possible scenarios with different choice considerations:

  1. The legislation is never passed. You will continue to be able to make mega-Roth contributions to your 401(k) as well as backdoor Roth contributions (at least until the government decides to target these tax breaks at some future time).
  2. The legislation is passed and these two retirement account capabilities are eliminated as of the date of passage. In that case you should make your mega-Roth 401(k) and backdoor Roth contributions as early as possible to avoid losing the opportunity to do so after passage. Keep in mind that only earned income can be contributed to retirement accounts, so don’t make any contributions beyond what you’ve earned so far.
  3. The legislation is passed and these capabilities are eliminated retroactive to the beginning of 2022. In that case if you make any mega-Roth contributions now you would be faced with a Catch-22: the need to have them withdrawn from your 401(k) (together with any associated accrued earnings) without any way to do it.

We currently don’t know which scenario will play out. There’s been a lot of discussion on this topic among financial planners and I would assume our political leaders should have gotten the message already about the problem with scenario 3. But if that turns out to be the way they pass the law, we would then have to hope Congress recognizes the problem and acts quickly to fix it.

What should you do? There’s not much risk in making backdoor Roth contributions now so you might as well go ahead if you’ve already earned the amount you’re planning to contribute and can afford to save the cash. Regarding the 401(k), you can do the same if you’re willing to take the risk. Otherwise you might want to wait before making any mega-Roth contributions. As Clint Eastwood would say, “Do you feel lucky?”

Leave a Reply

Your email address will not be published.

This site uses Akismet to reduce spam. Learn how your comment data is processed.