Are Roth Conversions Going Away? The Current Law

A Roth conversion is a financial transaction where you move funds from a traditional, pre-tax retirement account, such as a 401(k) or traditional IRA, into a Roth account, which is funded with post-tax dollars. This process requires you to pay income tax on the converted amount in the year the conversion takes place. The primary benefit is that future qualified withdrawals from the Roth account are tax-free. The long-term viability of this strategy has been a topic of legislative debate, leading many to question if Roth conversions might be restricted in the future.

These discussions in Congress have created uncertainty for those who use or plan to use Roth conversions as part of their retirement strategy. The possibility of new laws targeting these conversions has prompted savers and investors to pay closer attention to developments in Washington. Understanding the history of these proposals and the current state of the law is important for making informed financial decisions.

A History of Proposed Changes

Concerns about the future of Roth conversions are rooted in legislative proposals aimed at limiting their use, particularly for high-income individuals. The most prominent of these efforts was embedded within the Build Back Better Act, a bill that received attention in 2021. Although the bill did not pass, its provisions offered a clear view of how Congress might approach changes to retirement savings rules to close what some lawmakers see as tax loopholes.

A feature of the proposed legislation was the prohibition of Roth conversions for both IRAs and employer-sponsored plans for single taxpayers with taxable income over $400,000 and married couples filing jointly with taxable income over $450,000. This measure was intended to prevent the wealthiest taxpayers from moving large pre-tax balances into Roth accounts, thereby avoiding future taxes on growth and distributions.

The bill also took direct aim at the “backdoor” Roth IRA and the “mega-backdoor” Roth IRA. The backdoor Roth IRA strategy is used by individuals whose income is too high to contribute directly to a Roth IRA. It involves making a non-deductible contribution to a traditional IRA and then promptly converting it to a Roth IRA. The Build Back Better Act proposed to eliminate this by prohibiting the conversion of any after-tax contributions from an IRA to a Roth account, regardless of income level.

Similarly, the “mega-backdoor” Roth strategy was targeted. This technique is available to individuals whose 401(k) plans allow for after-tax contributions beyond the standard employee deferral limits. These after-tax amounts could then be converted to a Roth 401(k) or Roth IRA. The proposed legislation would have banned the conversion of all after-tax employee contributions in qualified plans. These historical proposals, while unsuccessful, established a precedent for future legislative discussions.

The Status of Roth Conversions Under Current Law

Despite past legislative proposals, Roth conversions remain a legal strategy under current federal tax law. The proposed income restrictions and other limits did not become law, leaving existing rules in place. As of today, there are no federal income restrictions preventing an individual from converting funds from a traditional retirement account to a Roth IRA.

The standard conversion process, where an individual moves funds from a traditional IRA or an old 401(k) to a Roth IRA, is unaffected. Taxpayers can convert any amount they choose, as there are no caps on the value of assets that can be converted in a given year.

The “backdoor” Roth IRA strategy also remains viable for individuals whose income exceeds the limits for direct Roth IRA contributions. The “mega-backdoor” Roth IRA strategy is also still available for those whose employer-sponsored 401(k) plans permit after-tax contributions and in-service conversions to a Roth account.

The Legislative and Tax Policy Context

The legislative interest in limiting Roth conversions stems from fiscal and policy considerations within the federal government. Lawmakers frequently examine the U.S. tax code for ways to increase federal revenue, and retirement account rules are often part of that discussion. Strategies like backdoor and mega-backdoor Roth conversions are viewed by some as “tax expenditures,” which are provisions in the tax code that result in reduced tax revenue.

From a policy perspective, the debate centers on tax fairness. Critics of these conversion strategies argue that they disproportionately benefit high-income earners who have the financial means to make large conversions and pay the upfront tax. Because these individuals are otherwise prohibited from making direct Roth contributions, the backdoor and mega-backdoor methods are seen as loopholes that circumvent the original intent of the law.

Raising revenue is another primary motivator behind the proposed restrictions. When an individual performs a Roth conversion, they pay income tax on the converted amount in the current year. While this generates short-term revenue, the government forgoes the ability to tax the future growth and distributions from that account. By restricting or eliminating these conversions, the government would preserve a long-term revenue stream from future required minimum distributions (RMDs).

The ability to perform these conversions was initially expanded as a way to generate immediate tax revenue. Lawmakers recognized that allowing taxpayers to move money into Roth accounts would result in a short-term influx of tax payments. However, as high-income taxpayers have used these strategies to shelter large sums from future taxes, the long-term revenue loss has become a greater concern for policymakers.

Strategic Planning Amid Legislative Uncertainty

The ongoing debate surrounding Roth conversions introduces legislative risk into long-term financial planning. While these strategies are currently permitted, the possibility of future changes means that individuals should approach their decisions with foresight. The potential for new laws should be a factor in the decision-making process.

Strategic planning requires a thorough evaluation of one’s personal financial situation. A Roth conversion is a taxable event, and the decision to undertake one should be based on an analysis of your current and projected future income and tax rates. If you expect to be in a higher tax bracket during retirement, paying the tax on a conversion now at a lower rate could be advantageous.

The uncertainty of future tax laws adds another layer to this analysis. If you are a high-income earner who might be affected by potential future restrictions, you may consider executing a conversion sooner rather than later. This calculation depends heavily on individual circumstances, including your age, income level, and the size of your retirement accounts.

Tax laws are subject to change, and what is permissible today may be different tomorrow. Regularly consulting with a qualified financial advisor or tax professional can help you stay abreast of the latest legislative developments. This proactive approach allows you to adapt your strategy as needed and make decisions that align with your long-term retirement goals.