Legislative Threat to Mega Backdoor Roth Conversions

The Build Back Better Act would limit tax benefits for backdoor Roth conversions

 Mega backdoor Roth IRA and Roth 401(k) conversions are tax-shelter strategies that roll over or “convert” traditional IRA and 401(k) retirement account balances into Roth vehicles that then provide permanent tax-free treatment to the accounts’ distributions.  Although the two versions involve some technically different features, both strategies have attracted the financial media and tax policymakers and are threatened by the Build Back Better Act (BBB), recently passed by the House of Representatives and now pending in the Senate. 

To understand why these legislative measures are being proposed, it helps to briefly review how these mega conversions are structured and carried out. Then you'll get the details on how proposed legislation targets these strategies.

How Do Mega Backdoor Roth Conversions Work?

Rollovers of individual retirement accounts (IRAs) and 401(k) accounts into Roth IRAs and Roth 401(k)s, respectively, are increasingly used to amass huge, tax-free investments in personal and corporate retirement plans. One version of these tax strategies utilizes “backdoor” conversions of traditional IRAs to Roth IRAs, while a second, similar strategy converts regular 401(k)s to designated Roth 401(k)s or Roth IRAs.

Key Takeaways

  • Backdoor conversions of traditional IRAs and 401(k)s to Roth IRAs and designated Roth accounts increasingly are used by high-income taxpayers to shelter retirement savings from taxation.
  • Media accounts have identified very wealthy individuals who have used Roth accounts to create tax-free investment portfolios valued in hundreds of millions of dollars.
  • The growth of tax-benefitted, “mega” retirement accounts has prompted legislative action in the pending Build Back Better (BBB) bill to limit their size and require minimum distributions regardless of the owners’ age.
  • Beginning in 2022, the BBB bill would prohibit the transfer of after-tax assets; in 2029, caps would apply to high-income taxpayers’ aggregate retirement accounts balances and required minimum distributions (RMDs) would be mandated from such accounts, regardless of the owners’ age.
  •  After 2031, if the BBB retirement account changes are enacted, high-income taxpayers would not be allowed to make backdoor IRA and 401(k) conversions into Roth accounts. 

Generally only taxpayers whose modified adjusted gross incomes (MAGI, i.e., AGI adding back certain deductions and exclusion) are below statutory ceilings—$208,000 for married couples and $140,0000 for single taxpayers in 2021—are permitted to create a Roth IRA.

But actually, there are a variety of ways in which taxpayers whose incomes exceed the limit can find legal routes to benefit from Roth vehicles. Banks and investment firms, including those catering to individuals, increasingly promote Roth IRA conversions to their clients for the benefits they provide.

Tax Benefits of Roth IRA Conversions

Holding retirement investments in Roth IRAs and Roth 401(k)s provides tax benefits greater than those afforded investments held in regular IRAs and 401(k)s. Both traditional and Roth IRAs and 401(k)s are not subject to tax so long as their earnings are retained in the accounts. At the time that regular IRAs and 401(k)s are converted to Roth vehicles, the amounts that represent pre-tax contributions and any untaxed earnings are subject to tax. If the “converted” investments in the Roth vehicles are then held for a number of years, the taxes due in the year of the conversion can be minor compared to the potential long-run tax savings.

Here's why: While previously untaxed amounts in traditional IRAs and 401(k)s are taxed when distributed to the owners, distributions from Roth accounts are completely tax-free. Moreover, unlike traditional IRAs and designated Roth 401(k) accounts which generally require distributions to begin when the owner reaches age 72 or retirement, if later, Roth IRAs are not required to make any distributions during the life of the owners.

Over time the permanent tax-free status of investments held in Roth IRAs can produce significant tax savings and thereby net greater returns for owners or their heirs. Media reports about the build-up of enormous holdings in Roth vehicles, especially highly publicized accounts of the use of Roth IRAs by the ultra-rich, have prompted tax policy officials to investigate and propose limits on the size of these accounts.

How Some Wealthy Taxpayers Create Roth IRAs

Below, details on the different routes affluent taxpayers can use to acquire Roth IRAs. Each has triggered sections of the BBB bill designed to counter these strategies.

Taking Advantage of Low MAGI Years

Eligibility to create a Roth IRA depends on a taxpayer’s MAGI in a single year. Some extremely wealthy individuals been able to establish Roth IRAs directly without undertaking a conversion because their MAGI levels are low even though their unrealized investment returns may be substantial.

For example, some ultra-rich entrepreneurs and investors—who receive low wages and salaries and little other income while amassing fortunes as their capital investments appreciate and/or their businesses generate huge tax deductions—have met the income requirement and created Roth IRAs in low-income years. In addition, by investing their Roth IRAs in low-value assets, such as initial shares in nonpublic companies that subsequently appreciated greatly, some Roth IRA owners now have accounts worth hundreds of millions of dollars.  These mega accounts have prompted BBB provisions that would limit the aggregate value of an individual’s tax-benefitted retirement accounts.

401(k)s with Roth Features

Another route for high-income individuals is through 401(k)s, which have no income limitation for participation. A growing number of large corporations with many highly compensated employees now offer 401(k) plans that include a “qualified Roth contribution program.”  Participants in such plans have the option of investing all or a portion of their elective, i.e., previously taxed, income deferrals directly into designated Roth accounts.

For 2021, an employee’s maximum 401(k) contribution of pretax compensation for 2021 is $19,500 (plus a catchup amount of $6,500, if age 50 or older). If an employee makes elective, i.e., after-tax, deferrals to the 401(k) plan, this same ceiling applies to the employee’s total pretax and after-tax contributions. An employer can make additional contributions to a 401(k), which increases the annual limit in 2021 for combined employee and employer contributions to $58,000 ($64,500, if age 50 or older).

Nondiscrimination testing is required by law to ensure that employers do not create tax-benefitted retirement plans that discriminate in favor of key or highly compensated employees. These tests reduce otherwise applicable ceilings on contributions to traditional and Roth 401(k)s. However, employers offering Roth contribution programs generally have highly compensated workforces and their plans do not trigger these ceilings.

In addition to offering employees the opportunity to make elective contributions directly to designated Roth accounts, Roth contribution programs usually allow employees to roll over some or all of their traditional 401(k) plan balances into the designated Roth accounts. These rollovers can occur even before the employees are eligible to make distributions or transfers after termination of employment, from their traditional plans. Transfers from traditional 401(k)s and designated Roth 401(k) accounts to Roth IRAs also can be undertaken. While tax will be due on transfers of previously untaxed amounts from traditional 401(k)s, transfers from designated Roth accounts to Roth IRAs are tax-free.

Conversions of Traditional 401(k)s

Employees whose plans offer only regular, non-Roth 401(k)s also can execute backdoor conversions. However, transfers from regular 401(k)s to traditional IRAs generally are permitted only when a participant terminates employment, often at retirement from the plan sponsor. After terminating employment, they may roll over their balances into traditional IRAs. Then, they can roll their traditional IRA balances over into Roth IRAs. Tax will be due on previously untaxed amounts transferred to a Roth IRA account.

Roth Conversions: Eligibility and Distribution Timing

Under present law there are no income ceilings on taxpayers' eligibility to make transfers from 401(k)s and traditional IRAs to Roth accounts and no limits on the amounts transferred.

However, participants should be aware that to be tax-free, distributions from designated Roth accounts generally must be made on a date that is five years after the first contribution to the account, and that is (1) made on or after the date the participant reaches age 59½, or (2) is attributable to the participant being disabled, or (3) is made to the participant’s estate or beneficiary after the participant’s death.   

How Legislation Threatens Backdoor Conversions

The BBB legislation would initially limit—and eventually eliminate—the benefits of many backdoor Roth conversion strategies, especially mega conversions. If enacted, tax law changes scheduled to come into effect between 2022 and 2032 would prevent the use of Roth IRAs and Roth 401(k)s to maintain huge accounts that permanently escape taxation. In addition, new administrative rules, including expanded information reporting and income tax withholding, would facilitate greater IRS enforcement with respect to retirement plans. 

Prohibition of Conversion of 'After-Tax' Contributions in 2022

The House-passed BBB bill pending in the Senate would prohibit the rollover, i.e., transfer, of after-tax amounts from traditional IRAs and 401(k)s to Roth IRAs and Roth 401(k) designated accounts, respectively, beginning in 2022.  This restriction would limit such rollovers to pre-tax contributions that would be taxed upon the transfer. This change would apply to all taxpayers, regardless of income level.

Specific IRA Restrictions

In the case of IRAs, beginning in 2029, individuals who qualify as “high-income” would not be permitted to make additional contributions to their IRAs if the aggregate value of all their qualified retirement plans—i.e., traditional IRAs, Roth IRAs, annuity contracts, 457(b) deferred compensation plans, and defined contribution accounts—exceeds $10 million.

The bill also would prohibit an IRA account owner from contributing to, or acquiring for, their IRAs certain categories of assets that might present a conflict of interest, including investments in companies in which the IRA owner has substantial direct or indirect control or ownership. And after December 31, 2021, the statute of limitations for misreporting IRA asset valuations, and for any IRA prohibited transactions, would be extended from three to six years.

 New Limits for 'High-Income' Taxpayers

 After December 31, 2031, the BBB bill would eliminate Roth IRA and Roth 401(k) conversions entirely for high-income taxpayers. High-income taxpayers are defined as individuals having modified adjusted gross incomes that exceed $400,000 for single taxpayers and married persons filing separately, $450,000 for married individuals filing joint returns, and $425,000 for heads-of-households. The high-income thresholds would be adjusted for inflation.  

In addition, the BBB bill would increase the annual required minimum distribution (RMD) for high-income taxpayers with large retirement account balances for tax years beginning after December 31, 2028. (The statute uses the term "minimum required distribution" (MRD), instead of RMD.) Generally, the increased RMD rules would apply if the aggregate value of a high-income taxpayer’s qualified retirement plans—including traditional IRAs, Roth IRAs, annuity contracts, 457(b) deferred compensation plans, and defined contribution accounts—exceeds specified amounts at the end of the prior year. RMDs would be mandatory even if the owner had not attained the regularly applicable mandatory distribution age of 72.  With this change, substantial Roth IRAs that have no distribution requirement under present law during the owner's lifetime, would be required to make distributions.

A high-income taxpayer’s increased RMD generally would equal 50% of the excess of the total value of all the taxpayer’s qualified retirement plans over $10 million at the end of the prior tax year. If the aggregate value of a taxpayer’s qualified retirement accounts exceeds $20 million, the increase in the RMD would be the excess over $20 million, up to the lesser of (a) the amount required to reduce the total balance to $20 million or (b) the aggregate balance of the taxpayer’s Roth IRAs and designated Roth 401(k) accounts. Income tax withholding on such increased RMD amounts, other than nontaxable Roth amounts, would apply at the rate of 35% instead of the present rate of 10% for non-periodic distributions.

Administrative Rules

The BBB bill also would impose on plan administrators new tax-reporting obligations for distributions from accounts with high balances beginning in 2029.  Administrators would have to file annual reports about defined contribution plan account balances in excess of $2.5 million with the IRS and the plan participant. In addition, information about such accounts would be required in the plan’s annual registration statement filed with the Department of Labor.  

What Are Backdoor Roth Conversions?

There are two forms of Backdoor Roth conversions: the conversion of a traditional IRA into a Roth IRA and the conversion of a 401(k) account into a designated Roth 401(k) account or Roth IRA.  Pre-tax funds—i.e., money and investments not taxed before contribution to the traditional IRA or 401(k) and any earnings in the account—are taxed upon their transfer to the Roth entities. Backdoor Roth IRA conversions are conducted at the individual owner’s discretion. However, backdoor conversions of traditional 401(k) plans are available to plan participants only if the 401(k) plan allows such transactions.

What Are the Benefits of Roth Conversions?

When the tax due, if any, on the transfer of assets to the Roth entity is paid, all future distributions of converted funds and earnings from a Roth IRA or Roth 401(k) are tax-free. Distributions from traditional IRAs and 401(k)s are taxable (except for the amount of any after-tax contributions to such accounts).  If the assets in a Roth account appreciate significantly after the conversion, the tax savings can be enormous. In addition, if accounts are converted into Roth IRAs, no distributions are required from the Roth IRAs in the owners' lifetime.

How Would the Build Back Better Legislation Affect Backdoor Roth Conversions?

If enacted, the House-passed bill would limit the tax benefits of these conversions starting in 2022. For high-income taxpayers, the total aggregate value of their retirement accounts would be capped and increased distributions would be required beginning in 2029. After 2031, backdoor Roth conversions by high-income taxpayers would be prohibited. 

The Bottom Line

The enactment of the BBB bill and its inclusion of the provisions attacking backdoor Roth conversions are uncertain.  However, publicity about the abuse of Roth vehicles has motivated reform proponents. And, the potential $10 trillion in revenue to be gained from the provisions dealing with retirement plans makes these changes attractive components of the BBB, which the Biden Administration contends will pay for itself.

Article Sources

Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
  1. Congressional Record. "Tax Treatment of Rollovers to Roth IRAs and Accounts." H.R. 5476, Sec. 138311. Cong. Record House, H6556-6557, Accessed Dec. 14, 2021.

  2. Observer. “How Warren Buffett, Other Billionaires Build a Tax-Free Retirement Fortune.” Accessed Dec. 14, 2021.

  3.  ProPublica. “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.” Accessed Dec. 14, 2021.

  4. Joint Committee on Taxation. JCX-32-31. "Present Law and Background Relating to Retirement Plans. " https://www.jct.gov/publications/2021/jcx-32-21/ . Dec. 14, 2021.

  5. Congressional Record. "Tax Treatment of Rollovers to Roth IRAs and Accounts." H.R. 5476, Sec. 138311.. Cong. Record House, H6556. Accessed Dec. 14, 2021.

  6. Congressional Record. "Statute of Limitations with Respect to IRA Noncompliance, and Sec. 13813. IRA Owners Treated as Disqualified Persons for Purposes of Prohibited Transactions Rules." Cong. Record House, H.R. 5476, Sec. 138312. H6557. Accessed Dec. 14, 2021.

  7. Congressional Record. "Tax Treatment of Rollovers to Roth IRAs and Accounts." Cong. Record House, H.R. 5476, Sec. 138311. H6556 and 6557. Accessed Dec. 14, 2021.

  8. Congressional Record. " Increase in Minimum Required Distributions for High-Income Taxpayers with Large Retirement Account Balances." H.R. 5476, Sec. 138302. Cong. Record House, H6555 and 6556, Accessed Dec. 14, 2021.

  9. Congressional Record. " Tax Treatment of Rollovers to Roth IRAs and Accounts." H.R. 5476, Sec. 138301. Cong. Record House. H6555. Accessed Dec. 14, 2021.

  10. The Joint Committee on Taxation. JCX-47R-21. (November 23, 2021). Estimated Budget Effects Of The Revenue Provisions Of Title XIII – Committee On Ways And Means, Of H.R. 5376, The “Build Back Better Act," As Passed By The House Of Representatives. https://www.jct.gov/publications/. Accessed Dec. 14, 2021.

  11. Roll Call. “Delayed ‘mega IRA’ provisions boost budget bill’s revenue take.” Accessed Dec. 14, 2021.