Reading President Obama’s recently released budget proposal for 2016 is like reading a tax attorney’s playbook – many of the good tax savings ideas are in there, except the President wants to end them! One such proposal is to limit Roth conversions to pre-tax dollars. While I don’t expect any serious tax reform bills to be signed into law anytime soon, it is a good idea to familiarize oneself with existing “loopholes” in order to maximize tax savings while available.
What is it? A “backdoor” Roth IRA conversion refers to contributing after-tax money to a traditional IRA and then converting that traditional IRA into a Roth IRA. The reason for undertaking this convoluted procedure is that while contributions to a Roth IRA are limited based upon income levels, contributions to a traditional IRA are not, although the ability to obtain an income tax deduction by contributing to a traditional IRA is limited by income. Thus, a backdoor Roth IRA allows an indirect contribution to a Roth IRA when a direct contribution would not otherwise be allowed. No income tax is owed on the conversion of the original contribution dollar amount (since the traditional IRA contribution was, in this scenario, non-deductible) and the money can grow tax free in the Roth IRA. Furthermore, Roth IRA’s do not have required minimum distributions and are not subject to income tax upon receipt.
What would President Obama’s proposal accomplish? Roth IRA conversions would be limited to pre-tax contributions (and earnings thereon) to traditional IRAs, so this loophole would effectively be closed. The ability to convert pre-tax dollars in a traditional IRA would still be available, but income taxes will be incurred by the conversion.
Strategy: If this retirement savings/wealth accumulation strategy sounds interesting, get started. If you wait, you could miss out if tax reform is ever implemented. It is important to note, however, that there are pitfalls to any tax minimization strategy, and this one is no different. Consult your tax advisor prior to making the conversion to determine the tax effects, especially if you have other pre-tax retirement accounts.