Please ensure Javascript is enabled for purposes of website accessibility

Why Is Everyone Talking About the Mega Backdoor Roth IRA?

By Adam Levy – Sep 18, 2021 at 6:06AM

Key Points

  • Congress is looking to raise taxes on the wealthy to support President Joe Biden's spending plan.
  • Part of its plan is to close a couple of retirement savings loopholes.
  • The plan may have consequences for people besides the ultra-wealthy.

Motley Fool Issues Rare “All In” Buy Alert

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Congress' new tax proposal makes some big changes to retirement savings.

The mega backdoor Roth IRA is a tactic that can supercharge your retirement savings and help you shelter investment growth from taxes in retirement. Using the mega backdoor could allow you to contribute up to $38,500 to a Roth IRA per year. The House Ways and Means Committee thinks it's a loophole that only benefits wealthy Americans, and it should be closed.

In its recent tax proposal to help raise funds for President Joe Biden's $3.5 trillion social infrastructure plan, the committee includes several changes prohibiting both the backdoor Roth IRA and the mega backdoor Roth IRA. Specifically, it "prohibits all employee after-tax contributions in qualified plans and prohibits after-tax IRA contributions from being converted to Roth regardless of income level."

Here's how these changes might affect your retirement savings plans.

A box with a roll of cash labeled Roth IRA Tax Free.

Image source: Getty Images.

Shutting the mega backdoor

If your employer-sponsored retirement plan, like a 401(k), allows non-Roth employee after-tax contributions, you likely have access to an extra bucket of tax-advantaged savings capacity. 401(k)s allow up to $58,000 in total contributions between employee salary deferrals, employer contributions, and additional after-tax contributions. 

So, if you max out your 2021 contribution of $19,500, and your employer throws in an extra $2,500, that leaves $36,000 you could contribute on an after-tax basis. 

Some plans allow you to immediately convert those after-tax accounts into a Roth account, which means you'll never owe another dime of taxes on those investments. Other plans require you to wait until you depart your job, but you can then convert only the after-tax portion of the account to a Roth while converting the growth to a traditional IRA.

The tactic is called the mega backdoor Roth IRA because it allows you to move a massive amount of cash into a Roth IRA every year.

Congress wants to prohibit those after-tax contributions from employer-sponsored plans entirely.

No more IRA for you

Another piece of the proposal is that it also closes the regular backdoor Roth IRA. If you make above the income limit for a Roth IRA contribution, you can make an after-tax contribution to a traditional IRA and immediately convert it to a Roth. The income limits for 2021 are $140,000 for individuals and $208,000 for married couples. Those individuals are also well above the income limits for taking a deduction for IRA contributions.

The new tax proposal effectively makes contributing to an IRA of any type unappealing for savers above those income thresholds. Individuals will no longer be able to convert those contributions to a Roth IRA.

There are better tax advantages to be had by investing in a regular brokerage account than keeping after-tax funds in a traditional IRA. Not to mention the additional flexibility of keeping investments outside of a retirement account.

Why does Congress want to close these loopholes?

Congress views the mega backdoor Roth and backdoor Roth as ways for wealthy individuals to avoid paying their fair share in taxes. Indeed, you have to make a certain level of income in order to afford to contribute more than the maximum tax-advantaged contribution to a 401(k). 

Congress is looking for ways to raise taxes on the wealthy in order to fund government spending on expanded social programs. While these changes won't produce an immediate boost to tax revenue, they could provide future governments with more money as retirement savers are forced to put more of their savings in taxable investment accounts. 

When those investments grow and account holders sell to fund their retirement, the government will collect some taxes. With the mega backdoor Roth, investors wouldn't pay any tax on those sales.

That said, Biden promised not to raise taxes on families making less than $400,000 per year. There's a big gap between making enough to use the backdoor Roth and mega backdoor Roth tactics and $400,000 per year. While there's no immediate impact on taxation for those households, this certainly feels like a tax increase. So, additional changes to the tax code may be necessary to help Biden keep his promise.

The Motley Fool has a disclosure policy.

Invest Smarter with The Motley Fool

Join Nearly 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
371%
 
S&P 500 Returns
120%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 12/01/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.