Members of Congress recently proposed a provision that may disallow Roth IRA conversions for certain American households. Depending on your income, time frame, and retirement goals, now may be an opportune time to consider a conversion. Converting from a traditional IRA or 401(k) to a Roth allows your money to grow tax-free for the remainder of your lifetime.

Unfortunately, for some, the time may be running out to take advantage of converting to a Roth IRA. Here is what you need to know.

Tax Advantages of Funding a Roth IRA

As a refresher, Roth IRAs were created in 1998 to give lower-income Americans a new tool for retirement savings. They work in the opposite format of traditional IRAs or 401(k)s, which are funded with pre-tax dollars, grow tax deferred, and are taxed as ordinary income upon withdrawal (no 10% penalty after age 59.5).

This difference can be extremely beneficial for those who anticipate higher income in retirement. While it may seem unlikely, many retirees face this dilemma after accounting for Social Security, pensions, investment income, and required minimum distributions (RMDs).

Making Roth contributions has many distinct advantages, but unfortunately, not everyone is eligible to contribute. This makes conversions an attractive option for many.

What Is the IRA Conversion Loophole?

Roth conversions allow you to convert some or all of your funds from a pre-tax retirement account (i.e., traditional IRA) into a post-tax Roth IRA. This loophole allows those whose income is above the IRS Roth IRA contribution limits an alternative.

For the 2021 tax year, Roth contributions can be made if your modified adjusted gross income (MAGI) is less than $140,000 (single filer) and $208,000 (married filing jointly). Total contributions to traditional and Roth IRAs cannot exceed $6,000 for the year ($7,000 for those age 50 or older).

Example: If Stacy earns more than $140,000 as a single tax filer, she cannot contribute to a Roth IRA. However, Stacy can make nondeductible traditional IRA contributions and then convert the balance to a Roth IRA. The IRS does not limit the amount of money that can be converted from a traditional IRA to a Roth IRA.

For those who don’t qualify for Roth IRA contributions, a conversion can be worth looking into.

How Do Roth IRA Conversion Taxes Work?

The amount converted is treated as taxable income on your taxes in the year in which you convert. This amount is added to any other sources of income. It should be noted that you can both contribute and convert funds in the same calendar year. When converting, after-tax IRA contributions are treated differently from pre-tax from a tax perspective (more on that below).

An important step in retirement planning is analyzing how much to convert. You need to be mindful of the amount as it could propel you into a higher tax bracket. Retirees must be extra careful as conversions can increase their tax bracket and the percentage of their Social Security benefits that are taxed. Conversions can also expose them to Medicare surcharge premiums.

Also, depending on the converted amount, you may need to make estimated tax payments. Working closely with a financial planner or tax advisor can assist you in this process.

How Does the Mega Backdoor Roth Conversion Work?

While the standard backdoor Roth conversion works with a traditional IRA, some employers allow for “mega backdoor” Roth conversions with a 401(k) plan. You need to check your employer’s Summary Plan Description (SPD) to see if your plan is eligible.

In many cases, you can contribute up to $38,500 in after-tax money, which is in addition to the max of $19,500 to a 401(k). You can then convert the $38,500 in after-tax money to your Roth.

Conducting backdoor Roth conversions may result in unexpected tax bills. The process can be complex and involves following strict IRS rules and regulations. Working with a fee-only, fiduciary financial advisor can help you through the process.

The IRS has a pro-rata rule to determine how much of a distribution from an IRA is taxable when the account includes pre-tax and after-tax money. If your traditional IRA holds a high ratio of pre-tax money, you will pay taxes on a portion of your conversion.

· Example: Bob’s traditional IRA has $60,000 in pre-tax and $40,000 in after-tax contributions. Based on the pro-rata rule, 60% of Bob’s distributions, including conversions, are taxable upon withdrawal.

Despite the challenges of using a backdoor Roth conversion, the strategy remains a popular way for high earners to fund a Roth IRA.

Why Is Now the Right Time for a Roth IRA Conversion?

Currently, Congress is debating an infrastructure package, and changes to tax laws may help fund the government’s spending. Members of Congress have proposed a provision to end the backdoor IRA conversion loophole for certain taxpayers.

The proposal targets individuals with a taxable income of more than $400,000 and married taxpayers filing a joint return with a taxable income of $450,000.

The proposal includes several changes for taxpayers above the income threshold:

Higher required minimum distributions for larger IRAs
Elimination of Roth IRA conversions
Prohibition of conversions using after-tax contributions

Congress aims to eliminate Roth IRA conversions for those who make $400,000 ($450,000 for married couples). Eliminating this ability will close the “backdoor” strategy. If your income exceeds the threshold, the IRS will not permit you to make distributions, transfers, or contributions to a Roth IRA from another account. The good news? This provision would start in 2031, giving you a decade to continue using this strategy.

If your income does not exceed $400,000 ($450,000 for married couples), you do not need to worry about the previous provisions. However, the proposal would eliminate the “mega backdoor” 401(k)s for all taxpayers.

How to Deal with the Proposed Changes

If the proposal passes, it will prohibit high-earning taxpayers from converting funds from an IRA to a Roth and prevent anyone from converting after-tax 401(k) funds to a Roth.

No matter your income, you can contribute up to a total of $19,500 to a traditional or Roth 401(k), or a combination. You may still be eligible to contribute up to $38,500 in after-tax money, but you won’t be able to convert. Unfortunately, not all employers offer after-tax 401(k) and Roth 401(k) funding options.

Conclusion

You may soon miss out on the opportunity to convert a retirement account to a Roth IRA. The changes impact those who make over the income threshold and those who plan on converting money from a 401(k). Conversions can also be a useful estate planning tool for those who want to minimize taxes paid by their heirs upon their passing.

While Congress has not yet passed a bill to change the federal tax code, preparing for all outcomes may help cut your taxes during your retirement years.

Discuss your situation with a fee-only financial advisor.

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