Even though their incomes often exceed the phaseout threshold for funding Roth IRAs, physicians have been utilizing loopholes in the tax code to fund Roth IRAs for the past decade or more. Converting IRA funds to Roth IRA funds allows a taxpayer to change a tax-deferred IRA to a tax-free Roth IRA. In doing so, the taxpayer must pay taxes on the balance of the account that is being converted. For example, suppose you have $100,000 of IRA dollars being converted to a Roth IRA. In that case, you will essentially have $100,000 added to your taxable income for that tax year in exchange for the $100,000 account to be considered a Roth IRA.
In a somewhat expected move, it appears Congress has changed directions on allowing for many Roth conversions. For those who had incomes above the basic Roth IRA contribution limits, the backdoor Roth IRA funding loophole existed, and there was also a “mega” Roth IRA funding loophole. The 2021 tax year may be a last call for Roth IRA funding for individuals who exceed the income thresholds for normal Roth IRA funding.
Here are some Roth conversion strategies that appear to be going away in 2022:
1. The backdoor Roth IRA strategy was quite simple: Establish a nondeductible traditional IRA, fund it, then immediately convert the traditional IRA to a Roth IRA. There are no income limits to establish a nondeductible traditional IRA, so this loophole basically allowed anyone to fund a Roth IRA, as long as they knew the rules (and filed form 8606 with the IRS stating a nondeductible IRA was funded). The IRA was established as an after-tax account, so there was no taxable event, as long as the IRS was informed that no deduction on the IRA was taken, hence form 8606 must be filed.
2. The “mega” Roth IRA strategy is a bit more complicated, and not everyone is eligible to participate. This strategy involves an employer-sponsored retirement plan, where, if allowed by the retirement plan document, the participant can over-fund the retirement plan, above the deductible limits, and immediately convert and transfer the excess funds to a Roth IRA. In 2021, a participant could contribute and defer up to $19,000 to a retirement plan, but a defined contribution retirement (such as a 401(k)) can handle up to $58,000 of total contributions, which includes participant contributions and employer matching contributions. Once the participant contributes $19,000, and the employer matched the contributions, whatever amount remains ($58,000 – employer contributions – $19,000 deferred participant contributions = “mega” Roth funding) is eligible to be rolled into a Roth IRA. So if an employer had no matching and no profit sharing allocation, there could be up to $39,000 of annual Roth IRA contributions per year, assuming the retirement plan allowed for participant nondeductible contributions.
What’s not changing in 2022:
It appears the basic strategy of IRA conversions is still available. This strategy allows for deductible IRAs and/or deductible portions of IRAs to be converted to Roth IRAs. The benefit of converting a traditional IRA to a Roth IRA is to get the IRA account out of the IRA tax system; however, in doing so, you must pay income tax on the entire amount that is being converted. So what’s the difference in strategy vs. the others just mentioned? The main difference is the purpose of the basic IRA conversion is to pay tax now and convert balances of IRAs that have been involved in the traditional qualified plan system for all intents and purposes. The backdoor Roth contributions and “mega” Roth contributions are strategies to put new contributions into the Roth IRA system utilizing loopholes in the tax code to circumvent the Roth IRA income limits and/or the Roth IRA contribution limits. The main difference is old money vs. new money.
The 2021 contribution limit to Roth IRAs is currently $6,000 annually per individual, and the 2022 limit will not change (even though 401(k) limits increased for 2022). The income thresholds, however, will be raised. Let’s look at the changes to the income thresholds for Roth IRA contributions:
Roth IRA income limits for 2021 are currently:
- Single filers: $125,000 – $140,000
- Married filing jointly: $198,000 – $208,000
- Married filing separately: $0 – $10,000
Roth IRA income limits for 2022 will be adjusted to the following:
- Single filers: $129,000 – $144,000
- Married filing jointly: $204,000 – $214,000
- Married filing separately: $0 – $10,000
Why is there a range for the Roth IRA contribution limits? The range of income specifies a phaseout for contributions. The lower-income limit describes the amount of income the phaseout begins. The higher income limit describes when the phaseout ends, and the Roth IRA contribution is no longer available by ordinary means.
For example, if you are a single filer making $133,000 of annual income, how much can you contribute to a Roth IRA in 2022? The range to limit Roth IRA contributions for single filers in 2022 begins at $129,000 and ends at $144,000. The entire range is made up of $15,000 by subtracting the phaseout ranges ($144,000 – $129,000 = $15,000). The single filer making $133,000 makes $4,000 above the beginning phaseout threshold of $129,000. To determine the appropriate contribution limit for 2022, take 1 minus the quotient you get from dividing the difference of the income above the beginning phaseout threshold ($4,000) by the range of income threshold ($15,000). Then multiply the difference by the annual contribution limit. For example, the difference of income above the income threshold is $4,000 and the range of the threshold is $15,000. $4,000/$15,000 = 0.267. Take 1 – 0.267 = 0.733. Multiply 0.733 by the annual contribution limit of $6,000, and the single filer making $133,000 can contribute $4,398 for 2022. That seems a lot trickier than it really is. Here’s the formula in longer form, which is much easier to consume:
The formula for calculating Roth IRA contributions when income falls within the phaseout limits:
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This formula works for both Roth IRA contributions and determining deductibility of Traditional IRAs – with a few exceptions.
What has changed? The loophole has closed to fund Roth IRAs outside of the normal channels of income and contributions limits.
What hasn’t changed? Normal Roth conversions should still be safe for a while (I heard Roth conversions would be reviewed again in about a decade, but who really knows?). Also, you can’t file married filing separately to allow a spouse with a lower income to capitalize on Roth contributions. Many physicians file married filing separately to lower-income to keep student loan payments lower for Public Service Loan Forgiveness purposes.
While converting IRAs to Roth IRAs isn’t necessarily going away, funding Roth IRAs for those above the income thresholds or above the annual contribution limits is going away in 2022. For many physicians earning income above the Roth IRA funding limit threshold, the backdoor Roth” contribution was an annual exercise in tax planning, so if that is a strategy you have been accustomed to executing, 2021 might be the last call for your final Roth IRA contribution.
Paul Morton is an investment advisor, Midwest Private Client Group.
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