Is This the End of the Back-Door Roth IRA Tax Loophole?

By Brittany Lyte on 12 March 2015 0 comments

One of America's most beloved tax-trimming strategies may soon be outlawed.

Deep inside President Barack Obama's proposed Fiscal Year 2016 budget is a measure — "Limit Roth conversions to pre-tax dollars" — that could put the kibosh on a practice used by high earners to dodge the income limits on Roth IRA contributions. The verbiage in the budget proposal is succinct, and therefore unclear. But experts say those six little words could stop high earners from contributing to their Roth by way of the back-door strategy.

What's the Big Deal With Back-Door Roths?

The Roth IRA offers account holders something very valuable: tax-free income in retirement. Since contributions to Roths are made using after-tax dollars, these accounts are not taxed as they grow, and no tax money is due when funds are withdrawn in retirement. The catch is that you can only directly contribute to a Roth IRA if your income is below a certain ceiling. For jointly filing married couples, that limit is $191,000. For single filers, it's $129,000. Folks with income beyond those barriers may instead contribute to a traditional IRA account.

But high earners (who value the benefits of these Roth accounts as much as the everyman) have a way of dodging the contribution limits that prevent them from enjoying these tax perks. Using the back-door strategy, high earners can make after-tax contributions to a traditional IRA account, for which there are no income restrictions, and then convert that account into a Roth. This method affords all the benefits of a Roth account with few of the limitations. And it's precisely this practice that Obama budget proposal wants to eradicate.

Uncertainty Around the Proposal

"It seems to me they're saying that was a good workaround, but we don't want you to do it anymore," IRA expert and CPA Ed Slott told Forbes.

But Slott says ending the back-door strategy is not so simple. One issue with Obama's loophole closure proposal is that it doesn't jibe with the Internal Revenue Service's new rules on after-tax rollovers, which actually make it easier to convert after-tax dollars into Roth IRA accounts.

"They didn't look at the practicality of how it butts heads with the rules that we're working with now," Slott says.

Now, it's important to keep in mind that the president's budget is more of a wishlist than a decree. It's bound to get rewritten, trimmed, and cut as the budget vetting process continues in Congress. But it's an important indicator of what the administration is thinking. And if you're a high earner enjoying the benefits of back-door Roths, it may signal an upcoming change in your retirement planning.

Do you think back-door Roths should be eradicated? Why or why not?

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