Should Clients Convert to Roth IRAs Before the Backdoor Closes?

Legislation drafters are quietly looking for ways to squeeze more taxes out of turnips, and one candidate for juicing is the backdoor Roth individual retirement account conversion process.

High-income and high-net-worth clients might already be thinking about the possibility that overall tax rates might go up. And they might have given some thought to the possibility that estate taxes could spring back to what they were before the 2017 tax overhaul.

Your clients with too much income to make a direct Roth IRA contribution have likely heard of the backdoor Roth strategy, by which they can move assets from a traditional IRA to a Roth.

But they might not know that they can move an annuity purchased with pretax income into a Roth IRA, via the use of a traditional IRA.

(The income limit for making a full $7,000 IRA contribution is $146,000 for an an individual or $230,000 for a couple in 2024.)

Could clients lose out on something they wanted if the backdoor Roth strategy suddenly disappeared?

The strategy: A Roth conversion lets taxpayers move assets from a traditional individual retirement account or traditional 401(k) plan into a Roth IRA. The taxpayer must pay taxes on the assets converted but can collect investment earnings and make withdrawals that fall within certain guidelines free from additional federal income taxes. The strategy helps the taxpayer get around the usual contribution limits.

In some cases, wealthy taxpayers use the Roth conversion to create a steady stream of income, by putting an annuity inside the Roth, through the previously mentioned steps of moving the annuity into a traditional IRA and the traditional IRA assets into the Roth IRA,

Stan Haithcock discusses the topic in detail in his Stan The Annuity Man blog.

Ameriprise, Ameritas and Pacific Life are examples of companies that have posted guides on Roth conversions.

The history: The Internal Revenue Code provision that created the backdoor strategy has been in place since 2006.

In 2021, Jeffrey Hoopes, a law professor at the University of North Carolina at Chapel Hill, testified at a Senate Finance subcommittee hearing that he believes the backdoor Roth strategy is the result of one of the few true, unintentional loopholes in the U.S. tax code.

David Hemel, a University of Chicago law professor, and Steven Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center, gave the Senate Finance Committee a tutorial in written hearing testimony on how to use a “mega-IRA” to avoid millions of dollars in federal income taxes.

A team at the Congressional Budget Office estimated in 2016 that removing the backdoor by putting constraints on conversion could add $4 billion in federal income tax revenue over 10 years and make the tax code fairer.

Drafters put a backdoor Roth IRA provision in an early version of the bill that created the Inflation Reduction Act of 2022. But the House removed the section by the time the bill reached the floor.

Current conditions: Backdoor Roth strategies have not been in the headlines this year.