Roth IRAs: Effects of Closing the Mega Backdoor Loophole

Author: John Wang, Graphics: Carol Lu

The BRB Bottomline

The Roth IRA mega backdoor loophole is on the precipice of being closed by the Biden administration’s new tax plan. It could lead to unintended ramifications for the middle class.

Joe Biden’s presidency has ushered in a renewed drive by his administration to increase taxation on the wealthy. Part of their plan to do this includes closing loopholes in Roth IRA savings accounts that can be used to take home more money than that which an IRA would ordinarily yield. While this seems good at first glance, the plan, which masquerades as part of a growing social movement to reduce wealth inequity, may be a misguided attempt to increase funding for the administration that hurts everyday middle class households.

An IRA, or Individual Retirement Account, is designed to accept regular deposits throughout an individual’s time in the workforce, allowing the individual to accrue interest ahead of withdrawal at retirement. Traditional IRAs are injected with pre-tax dollars, allowing the individual to accrue interest on their raw income before being subject to taxation during the withdrawal. IRAs are considered a very useful retirement tool for people who have the patience and ability to periodically deposit a portion of their earnings over a long period of time.

Roth IRAs work slightly differently from traditional IRAs. A Roth IRA program allows an individual to deposit post-tax dollars, but the eventual withdrawal is tax-free given that certain rules and conditions are met. Roth IRAs also have contribution limits. You cannot contribute to a Roth IRA if your income is too highfor single people that ceiling is currently $140,000 per year, and for married couples it is $208,000. The amount of money that can be contributed annually is also regulated. For single individuals, that number is currently $6,000 ($7,000 if the individual is age 50 or older). 

However, over the years, investors have come up with ways to skirt around those limits. A method called the mega backdoor is a loophole exercised by contributing after-tax dollars to a traditional 401k, then converting it into Roth, either in the form of a Roth 401k or a Roth IRA rollover. With the mega backdoor, the effective ceiling for annual contributions shoots up to $38,500. 

President Biden’s new tax plan looks to close that mega backdoor loophole. The House Ways and Means Committee is proposing a bill stating that “all employee after-tax contributions in qualified plans and prohibits after-tax IRA contributions from being converted to Roth regardless of income level.” This shouldn’t come as a surprise. Politicians have been working to close this loophole for years, and not just Democrats. Republicans also targeted it in a 2017 bill, but the current proposal is the closest Congress has yet come to closing the mega backdoor. 

Biden’s presidential campaign promised to increase taxes on the wealthy, while maintaining the same level of taxes for the middle and working classes. Unfortunately, the Administration’s hope to close the Roth loophole is both consistent and contradictory with those promises. It does indeed intend to interfere with the moneyed class’s practice of expanding their wealth by abusing loopholes. The current loophole distorts the true intent of Roth IRAs, which were designed to help the middle class slowly invest their modest earnings into what will eventually be a comfortable nest egg providing retirement security. They weren’t intended to be yet another tool for the ultra-rich to evade taxes and soak in benefits on their millions upon millions. The proposed bill backed by the Administration, however, has a number of flaws. 

It’s unclear whether closing the mega backdoor loophole will actually be effective. It’s reasonable to assume that if the loophole closes, the wealthy will simply move their assets to other irregular retirement programs without increasing effective taxable earnings and savings. Furthermore, the administration’s plan hinges on the misguided assumption that only the wealthiest of the wealthy abuse the Roth IRA mega backdoor method. In his campaign, President Biden set an income tax floor increase at $400,000, effectively promising that those who earned less than that amount would not have their taxes raised. However, the threshold of income needed to use the Roth IRA mega backdoor is far below $400,000. The idea that the mega backdoor only benefits the ultra wealthy therefore creates a grey zone regarding the Administration’s policy towards taxing the middle class’s assets. Closing the loophole will therefore affect a large demographic of middle and upper-middle class households.

The principal goal of the bill involves more than just balancing wealthit’s about increasing tax revenue. The idea is that if the federal government closes the Roth IRA mega backdoor, severely restricting the amount of money that can be contributed, then the wealthy will pivot to taxable investments as an alternative retirement saving mechanism. Tax revenue will thereby increase and the government will then be able to fund more of their programs with this money. But once again, the current plan can’t simultaneously increase the taxes drawn from the wealthy and not adversely impact the middle classes.

President Biden’s Administration faces a tax policy crossroad. It could close the loophole exactly as planned, implicitly defying a promise that contributed to his victory in 2020 and potentially alienating a portion of his support base. Alternatively, The Administration could end up not closing the loophole and leave themselves open to political attacks on the left for being weak on tax reform. The administration could also employ a combination of both these directions: closing up the loophole in conjunction with modifying tax laws and retirement investment regulation for the middle class. Doing so could nullify some of the negative effects felt by the middle class, but would likely be extremely politically costly at a time when the Administration suffers from limited Congressional cooperation. Either way, investors interested in securing their retirement should pay attention to the likely updates and potential changes in the regulations of a Roth IRA. Their plans for retirement investment may be on the cusp of being radically changed.

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