We don’t normally invest much energy in discussing pending legislation until it becomes law. However, the Build Back Better reconciliation bill introduced in Congress on September 13 creates a time-sensitive opportunity for Roth conversions of after-tax dollars.
Beginning in 2022, after-tax dollars can no longer be converted to Roth IRAs if the bill passes. This would eliminate backdoor Roth contributions after December 31. The benefit of conversion is that future earnings on those after-tax dollars become tax-free once inside the Roth.
Unfortunately, we can’t wait to see if the law passes prior to taking action. It takes time to complete a Roth conversion, and often times these bills are passed at the very last minute. So, for this provision, our suggestion is to proceed as though this portion of the law is going to pass.
If you’re unsure whether you have after-tax money in your retirement plans, this blog post shows you how to tell.
Roth conversion if you have after-tax money in your 401k
Still working for the employer and under 59 ½: you can talk to your plan administrator about in-plan Roth conversion. With in-plan conversion, you pay tax on the earnings accumulated since contribution. For example, if you had contributed $50,000 in after-tax funds to your 401k and it was now worth $75,000, you would convert $75,000 to Roth inside the plan. Of that conversion amount, $25,000 would be subject to income tax this year. You would receive a 1099R to include in your 2021 taxes.
If you’ve separated from service: you can do a full rollover of the plan to IRAs. The after-tax contribution amount can roll to a Roth IRA with no tax liability. The pre-tax portion of the plan (including both pre-tax contributions/earnings and earnings on the after-tax contributions) can roll into a traditional IRA. This option is appealing because you get to convert your after-tax contributions while continuing to defer taxes on the earnings.
Still employed and over 59 ½: Your employer may permit an in-service full distribution. If this is permitted without loss of any matching or other benefits, you may be able to execute the same strategy described under “separated from service.” Please talk to your plan administrator about options.
If you have after-tax money in IRAs
When you do any Roth conversion of IRAs, you are subject to the pro-rata rule. For example, if you have $50,000 of non-deductible (after-tax) contributions in your IRAs and your total balance in all IRAs is $250,000, 80% of any Roth conversion would be taxed as regular income. All traditional IRAs (including SEP and Simple) are included in this calculation. This rule can make Roth conversions unappealing when your pre-tax balance in IRAs is far higher than the after-tax balance.
However, there’s a workaround. If you have access to an employer qualified plan (401k) that accepts incoming rollovers, you can roll the pre-tax balance into the plan. Qualified plan balances don’t count in the pro-rata calculation. So, in our example, if you roll $200,000 into your employer’s 401k, the remaining $50,000 after-tax balance is the only IRA balance remaining. So, you can then convert the $50,000 tax-free. With this strategy, it’s important that you don’t roll the money back out of the plan prior to December 31st this year. There are also other potential pitfalls, so it’s important to consult with your financial planner or tax advisor.
The bottom line is if you have after-tax dollars in retirement plans, please consider your options sooner rather than later. If the law passes, you may not get the option to convert in the future.
Disclaimer: This is a complex subject with many potential caveats that could apply to your individual situation. Please consult with a financial planner or tax advisor to make sure you understand the full effect of any of these actions for you. You may also find this page on the IRS website helpful.
Here are other 2021 year-end planning opportunities created by the Build Back Better bill.