Managing Money

It’s not unusual for Congress to change the rules in the middle of the game, and it’s looking to do so now with proposals that would eliminate the so-called “backdoor” Roth strategy. While there are several ways a federal employee can execute a backdoor Roth strategy, all involve converting after-tax money from a tax-deferred retirement plan to a Roth IRA.

The most common method a federal employee may take advantage of, which I’ll refer to as the traditional backdoor Roth strategy, is utilized when an individual’s income is too high to make an annual Roth IRA contribution directly (for 2021, individuals with income greater than $140,000 and couples with income over $208,000 are prohibited from making a Roth IRA contribution).

Rather than contributing directly to a Roth IRA, the traditional backdoor Roth strategy involves first making a nondeductible traditional IRA contribution (there are no income limits for this type of contribution) and subsequently converting that nondeductible contribution to a Roth IRA. The money ends up in a Roth IRA but via a conversion rather than a direct contribution. Once the money has been converted to the Roth IRA, the future earnings on the backdoor Roth contribution may be distributed tax-free with a qualified withdrawal.

In addition to the traditional backdoor Roth strategy, certain federal employees have a couple of opportunities to fund what’s now referred to as mega-backdoor Roth strategies. One method involves using the Voluntary Contribution

Program (VCP), which is funded with nondeductible (after-tax) contributions that may be converted to a Roth IRA.

The VCP is only available to Civil Service Retirement System (CSRS) participants, who may contribute up to 10 percent of their federal lifetime earnings, providing an opportunity to funnel hundreds of thousands of dollars into a Roth IRA.

The other mega-backdoor Roth strategy involves making after-tax contributions to a 401(k)-type retirement plan. Not to be confused with Roth contributions (which are also made with after-tax dollars), after-tax contributions are held in the traditional balance, so any earnings associated with after-tax contributions accumulate tax-deferred and are taxed when distributed.

Not all 401(k) plans permit after-tax contributions, but when they do, the after-tax contributions may either be converted to the Roth 401(k) account—assuming the 401(k) offers a Roth account and permits in-plan conversions—or converted to a Roth IRA when the participant is eligible to take withdrawals.

After-tax contributions to a 401(k)-type plan are in addition to the normal salary deferral contributions made to the traditional and Roth 401(k) balances, which for 2021 are limited to $19,500 ($26,000 for those over age 50). On top of the salary deferral limit, the IRS has an overall contribution limit relating to 401(k)-type plans, which applies to all sources of contributions— salary deferral, employer contributions and after-tax contributions. For 2021, this limit is $58,000 ($64,500

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including the $6,500 age 50 and older catch-up contribution).

The Thrift Savings Plan (TSP) does not permit after-tax contributions, but there are a few federal agencies that, in addition to the TSP, offer a 401(k) plan that does permit after-tax contributions.

Congress has the backdoor Roth strategies in its crosshairs, and the traditional backdoor Roth strategy very likely will be eliminated. So will the mega-backdoor strategy involving in-plan conversions of after-tax contributions to the Roth account within a 401(k)-type plan.

It’s not certain, however, if the new rules will prohibit the conversion of after-tax contributions in an employer-based retirement plan to a Roth IRA after separating from service. If this is still allowed, CSRS participants utilizing the VCP to fund a mega-Roth may be safe. Federal employees making after-tax contributions to a 401(k) would also still be able to eventually get those contributions to a Roth IRA.

It’s probable that the new rules applying to backdoor Roth strategies will take effect after December 31, 2021. With the deadline fast approaching, it’s imperative you act now.

MARK A. KEEN, CFP®, IS PARTNER, KEEN & POCOCK, AND AN INVESTMENT ADVISER REPRESENTATIVE AND REGISTERED PRINCIPAL OF THE STRATEGIC FINANCIAL ALLIANCE, INC. (SFA). SECURITIES AND ADVISORY SERVICES ARE OFFERED THROUGH SFA.

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