I was scrolling by cnbc.com earlier this week when the following article caught my eye: House Democrats propose new retirement plan rules for the rich, including contribution limits and a repeal of Roth conversions. An end to backdoor Roth IRA and mega backdoor Roth 401k conversions? Panic? Nah. Turn off the lights the party’s over? Not yet. Have a plan to adjust? Seems wise.
I’ve doing backdoor Roth IRA conversions for a number of years even some years when I could’ve went in the front door with direct Roth IRA contributions. Part of this was planning for the day when Mrs. Dress Pockets and I would tie the knot and embrace the marriage tax penalties awaiting us by combining our incomes on one joint return. Closing the backdoor Roth IRA would simply shift $12,000 per year ($6k each) from our Roth IRAs to our after tax brokerage account. We’ve paid the income tax on the $12,000 either way and this becomes additional cost basis in the after tax account.
We simply lose out on tax free earnings of approximately $1,200 per year (10%). When we sell these shares in the after tax brokerage account, we will pay capital gains taxes ideally at a lower rate than income taxes. Now that $1,200 of tax free earnings does add up quickly due to multiple years of backdoor Roth IRA conversions and compounding but so it goes. It always seemed to me they should have prohibited backdoor Roth IRA conversions or significantly increased the income limit on direct Roth IRA contributions to make the backdoor less utilized.
It was late 2018 when I stumbled upon mega backdoor Roth 401k conversions. Wait you mean the $19,500 401k contribution limit (2021) is only for for direct employee tax deferred and/or Roth 401k contributions? There’s a less well known option to contribute additional after tax money to your 401k and a higher $58,000 total 401k contribution limit (2021) that encompasses the $19,500 employee contributions, any employer match and employee after tax contributions. Who knew?
Why would someone want to do after tax contributions to a 401k over a brokerage account? Let’s say you have this after tax money in your 401k. You then call up your 401k administrator with each paycheck or as the spirit moves you and ask them to convert that after tax money to the Roth 401k bucket so the earnings are tax free forever more. You only pay income tax on the gains the after tax money made between contribution and conversion. Clever. Your 401k administrator adds a pull-down menu to automagically convert after tax contributions to Roth 401k immediately with each paycheck resulting in $0 in additional income tax. Genius. But in hindsight perhaps the beginning of the end.
For the mega backdoor Roth 401k strategy to work you need an employer that allows after tax contributions and allows manual or automatic Roth conversions. Not all do. Truthfully I went down this path because Mrs. Dress Pockets was able to contribute to both a 403b and 457b and my mostly healthy sense of coopetition kicked in to match her without finding a government or nonprofit job with a 457b.
Should the mega backdoor Roth 401k loophole be closed down? Most likely. As you can go from a $6k backdoor Roth IRA conversion to an additional 3-6 times that depending on your employer match. So what would I do with the $15,000 in mega backdoor Roth 401k conversions I’ve done each of the past 3 years? Again I’ve paid income and FICA tax on this already, so it’s simply going to increase my paycheck and find its way to the after tax brokerage account as basis. Alternatively perhaps we spend a bit more money on home improvements or buy that minivan we seem to need more with each passing week.
My brother sent me this better link if you want to further dive down the rabbit hole of tax law proposals. Before the proposals become law, the U.S. House of Representatives and U.S. Senate need to be in the same tax universe, the Democratic party needs to pass this tax legislation with a razor thin budget reconciliation vote margin, and the President needs to sign it. Only then does that after tax to Roth 401k conversion pull-down menu disappear. Until it’s gone, I will use the levers at my disposal. And when either I or Mrs. Dress Pockets retire, we have the income headroom to do direct Roth IRA contributions again assuming the other has employment income.
