Roth IRA Conversions: Backdoor Twists and Mega Turns

Initially, taxpayers could recharacterize a Roth IRA back to a traditional IRA within a certain period. This option was reassuring, especially when the value of converted Roth IRAs dropped, allowing taxpayers to undo the transaction. However, the Tax Cuts and Jobs Act of 2017 repealed this ability, reflecting shifting governmental attitudes toward IRAs. Now, once an IRA is converted to a Roth, it cannot be undone.

The 2019 Setting Every Community Up for Retirement Enhancement (SECURE) Act further illustrates political shifts in retirement savings policy. This act requires most non-spousal inherited IRAs to distribute the entire account within 10 years, replacing the previous rule allowing distributions over the beneficiary’s lifetime. This change significantly impacted prior IRA and Roth IRA conversion planning assumptions.

This new limitation on inherited IRA payouts enhanced the attractiveness of Roth IRAs. While distributions from an inherited traditional IRA result in taxable ordinary income over the 10-year period, a Roth IRA investment can grow tax-free until the end of the 10 years, at which point a fully tax-free distribution is made. This makes the Roth IRA a powerful estate planning tool for retirees with sufficient other assets to live on, allowing them to defer distributions for the full 10 years.

Another advantage of Roth IRAs over traditional IRAs is that Roth IRAs or 401(k)s have no required minimum distribution (RMD) requirement, which, for traditional IRAs in 2024, must start at age 73. This allows the Roth balance to continue growing tax-free throughout retirement.

It should be noted that there is a distribution limitation specific to Roth IRAs: the five-year rule. This rule mandates that you must wait at least five years after your first contribution to a Roth IRA before you can withdraw earnings tax-free. This rule applies to all Roth IRAs, including inherited accounts and conversions from traditional IRAs.

The Backdoor Roth IRA

A backdoor Roth IRA is a strategy used by investors whose income exceeds the Roth IRA limits to contribute to a Roth IRA through a non-deductible IRA contribution that is subsequently converted to a Roth IRA. In 2024, single filers with a MAGI above $161,000 and married couples above $240,000 are ineligible to contribute to a Roth IRA directly. The backdoor Roth strategy allows them to navigate around this income limitation.

Executing the backdoor Roth IRA strategy involves two steps:

1. Make a nondeductible contribution to a traditional IRA: This nondeductible contribution also has no income limits.

2. Convert the funds to a Roth IRA: Since taxes have already been paid on the nondeductible contribution, this conversion typically incurs little to no additional tax liability, depending on whether there are earnings on the contributed amount between the time of contribution and conversion. To minimize any earnings, and thus minimize taxes, the conversion is usually completed promptly after the nondeductible contribution.

A significant limitation for backdoor Roth conversions, however, is the “pro-rata rule.” This rule applies if you have other traditional IRA assets in addition to the nondeductible IRA contributions you wish to convert.

The pro-rata rule requires that a proportional amount of both pre-tax and after-tax funds be converted to a Roth IRA, based on the total balance of all traditional and nondeductible IRAs. This can result in a taxable conversion on the traditional portion, reducing the tax-free benefit of the conversion. Therefore, the backdoor Roth strategy is most suitable for investors who only have Roth accounts and no traditional IRAs.

To avoid the pro-rata rule, ensure there are no pre-tax funds in any traditional IRA accounts at the time of conversion. Investors with pre-tax funds in traditional IRA accounts should consider converting them to a Roth IRA before executing the backdoor Roth strategy. Alternatively, if the investor has access to an employer-sponsored retirement plan like a 401(k) that allows rollovers from traditional IRAs, they should consider rolling over any pre-tax traditional IRA funds into their employer’s 401(k) plan.

The contribution limits for a backdoor Roth IRA are the same as those for traditional and Roth IRAs. In 2024, individuals under 50 can contribute up to $7,000 annually, and those 50 and older can contribute up to $8,000. The deadline for making a nondeductible IRA contribution typically aligns with the federal income tax return filing deadline for that tax year, usually April 15 of the following year. There is no deadline for converting nondeductible IRA contributions to the Roth IRA.

The Mega Backdoor Strategy

The mega backdoor Roth IRA strategy allows individuals to make additional after-tax contributions to their employer-sponsored retirement plans, exceeding the 2024 employee contribution limit of $23,000, with an additional $7,500 catch-up contribution for those over age 50. The 2024 mega Roth contribution amount is $46,000, enabling a total after-tax contribution of up to $69,000, or $76,500 for those over age 50. However, not all employers allow these contributions, so it is crucial to check the employer’s plan before considering this strategy.

SECURE Act 2.0 of 2022 Roth IRA Changes

529 Plan to Roth Rollovers

Under the SECURE Act 2.0 of 2022, starting in 2024, taxpayers may roll over up to $35,000 from overfunded 529 plan accounts to Roth IRAs, provided the 529 accounts have been held for at least 15 years and the rollover is for the same beneficiary. Annual rollover amounts would be subject to Roth IRA contribution limits, and contributions made within the last five years are ineligible for the rollover.

Required Roth Catch-up Contributions

When originally passed, SECURE 2.0 required catch-up contributions made to qualified retirement plans by employees who earned $145,000 or more in the prior year to be made on a Roth basis beginning in 2024. However, IRS Notice 2023-62 established a two-year extension, delaying implementation until January 1, 2026. Additionally, starting in 2024, the catch-up amount will be indexed for inflation annually. Beginning in 2025, individuals aged 60 to 63 will be able to contribute an additional catch-up contribution of $10,000 to 401(k)s and similar plans each year.

No Mandatory RMDs from Roth Accounts

SECURE Act 2.0 eliminated the requirement for savers to take minimum distributions from their work-based 401(k), 403(b), or 457(b) plan Roth accounts. Plan participants already subject to Roth RMDs may discontinue distributions in 2024.

Allowance of Roth Contributions for Matching or Non-Elective Contributions

Effective immediately upon passage of SECURE 2.0, participants in employer-sponsored 401(k), 403(b), and 457(b) plans can now designate some or all matching contributions and non-elective contributions as Roth contributions. Previously, employer matches had to be allocated to an employee’s pre-tax account.

Peter Thiel’s Roth Success and the Resulting Political Backlash

One of the most publicized Roth accounts belongs to Peter Thiel, as disclosed in the 2021 ProPublica article “Lord of the Roths: How Tech Mogul Peter Thiel Turned a Retirement Account for the Middle Class Into a $5 Billion Tax-Free Piggy Bank.” In 1999, Thiel, a co-founder of PayPal, had an income of $73,263, below that year’s Roth income threshold of $110,000. He contributed $2,000 to a Roth IRA, which was used to purchase PayPal shares. By 2003, when PayPal was sold to eBay, Thiel’s Roth PayPal shares were worth $28.5 million. By 2019, ProPublica reported that his Roth IRA had grown to approximately $5 billion.

In reaction to the ProPublica article, the House Ways and Means Committee drafted proposed legislation in 2022. This legislation aimed to prohibit wealthy individuals with retirement accounts exceeding $10 million from contributing extra savings and would have introduced new annual RMD requirements. Roth strategies such as the backdoor Roth and the mega Roth conversions would also be limited or eliminated. Although this proposed legislation was never enacted into law, it serves as a warning that these strategies could be modified or eliminated in the future.

For high-income earners who exceed the limits for direct Roth contributions, the Roth conversion, backdoor Roth, and mega Roth strategies are effective retirement planning techniques that can diversify retirement savings. These strategies are ideal for investors expecting higher taxes in retirement or those wanting to leave tax-free inheritances. However, as the Peter Thiel case and resulting political backlash have shown, there is always a concern that future tax law changes could modify the benefits of Roth IRAs. Proactive retirement planning now can result in significant benefits in the future for both retirees and their heirs.

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Daniel F. Rahill, CPA/PFS, JD, LL.M., CGMA is a wealth strategist at Wintrust Wealth Management. He is also a former chair of the Illinois CPA Society Board of Directors and is a current officer and board member of the American Academy of Attorney-CPAs.