Roth conversion? Why to gamble on one this tax filing season

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The tax season is in full swing, but there are still a few key moves that investors can make right now to lower their tax bills for last year and preserve their sanity. Here’s a look at four maneuvers that a financial advisor with a “holistic” approach to wealth management, which includes strategies to lower payments to the IRS, can shepherd clients through:

Go all out on contributions to retirement plans
Didn’t max out your contribution limits last year? The IRS allows contributions for 2021 to be made through April 15, 2022. That’s three days before this year’s April 18 filing deadline, which was extended due to the Emancipation Day holiday in Washington, D.C. Some contributions are deductible, so they’ll lower the total amount of income on which taxes fall, a savings to the taxpayer.

For 2021 returns being filed now, Americans could contribute a maximum $6,000, plus an extra $1,000 if aged 50 or older, to a traditional individual retirement plan (IRA) or Roth IRA. So an older married couple can put in a maximum $14,000.

Traditional IRAs are generally funded with money on which taxes haven’t yet been paid, while Roth plans are fueled by after-tax dollars. Pretax contributions grow tax-deferred, with the owner paying ordinary rates on future withdrawals. While investors can also contribute money on which they’ve already paid taxes, they pay ordinary tax on withdrawals, making after-tax contributions to a traditional IRA a double tax hit. In contrast, Roth plans grow tax-free, with no levies on withdrawals.

Deductions get complicated, depending on how much a taxpayer makes and whether she or a spouse has a workplace retirement plan. A traditional IRA owner who doesn’t have a workplace retirement plan (or whose spouse lacks one) or whose income is below $76,000 gets a whole or partial deduction. If a married couple filing jointly has one spouse with an employer-sponsored retirement plan, typically a 401(k), then an IRA contribution by the other spouse is no longer deductible once their joint income hits $214,000.

Straightforward Roth IRA plans are a little different. The contribution limits are the same. But while there are no income limits on who can contribute to a traditional IRA, contributions to Roth plans now are limited to people who made under $140,000 last year (under $208,000 for couples). Because their assets grow tax-free and don’t bear future taxes, Roth contributions aren’t deductible.

The Roth conundrum
It’s still not clear what might happen to so-called backdoor Roth conversions, a mainstay of large retirement accounts and estate planning for the wealthy, under stalled legislation in Congress. While emerging versions of the Build Back Better tax-and-spending bill aim to limit or ban the ability of high earners to own Roths through indirect methods, the legislation is mired in infighting by Democrats. But some tax and retirement experts think that it’s probably safe to take advantage of their current tax benefits, even as legislators work to curb them.

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Backdoor conversions involve an investor converting a traditional IRA into a Roth. They’re a way for wealthy people to sidestep the income limits for direct contributions to a Roth. An early version of the House bill banned conversions of after-tax dollars in IRAs and 401(k)s.

The House passed a somewhat softened version of that proposal last November. The legislation, which has to be passed by the Senate, would outlaw so-called mega-backdoor Roth conversions starting Jan. 1, 2022. The strategy came under a spotlight when ProPublica showed how PayPal co-founder Peter Thiel used it to transmute less than $2,000 worth of pre-IPO shares into a $5 billion account. The bill would still allow regular Roth conversions but would ban people with higher incomes from doing them starting in 2032. Last December, the Senate offered its own version of Build Back Better that proposes those same limitations.

The backdoor strategy involves using hefty after-tax contributions to a 401(k) plan that permits them. Under IRS rules, a taxpayer could put as much as $58,000 last year into a workplace retirement plan ($64,500 for those 50 or older). One chunk of the money reflects the maximum pre-tax amount of $19,500 ($26,000 if 50 or older), while the remainder, up to $38,500, reflects after-tax dollars. The limits include any company matches. The taxpayer then converts her 401(k) to a tax-free Roth. The higher amounts can swell a retirement portfolio far beyond what direct contributions to an ordinary Roth can.

Christine Benz, Morningstar’s director of personal finance, wrote in a Jan. 21 research note that it’s “unlikely” that when a final bill makes it to President Joe Biden’s desk for signature, if indeed one does, the proposed curbs would be retroactive to the start of this year.

“Given that these contributions and conversions are currently allowable,” she wrote, financial advisors have “been urging their clients to go ahead with them until the law officially changes." Benz quoted Aron Szapiro, the head of retirement studies and public policy for Morningstar, as saying that the likelihood of a retroactive ban on after-tax contributions is "close to zero.”

Of course, nothing’s final on Capitol Hill until it’s final. Nonetheless, Benz wrote, “given that backdoor Roths are one of the few mechanisms that higher-income heavy savers can use to achieve tax-free withdrawals and avoid RMDs in retirement, many such savers are apt to conclude that it’s a risk worth taking."

Get schooled
The college and private K-12 school savings plans known as 529s are popular with advisors. Similar to Roths, they’re funded with dollars on which taxes have already been paid. Withdrawals are tax-free when put toward tuition, housing, lab fees, books, computers and other college-related expenses.

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The plans don’t have annual contribution limits. But the IRS considers contributions to be gifts for federal tax purposes. That means a donor can exclude up to $15,000 for 2021. Amounts above that level count against the taxpayer’s lifetime estate and gift tax exemption amount ($11.7 million for 2021, double that for married couples).

The plans are run by more than 30 states and the District of Columbia. State rules vary on contribution deadlines. Most states set Dec. 31 as the deadline, but a few, including Georgia, Iowa, Mississippi, South Carolina, Oklahoma and Wisconsin, allow contributions until April 15 of the subsequent year, according to savingforcollege.com.

Organize your pandemic chaos, and don’t mess up
When advisors and accountants refer to the 2022 filing season, which opened on Jan. 24, they mean federal and state returns that must be filed for income earned in 2021.

With the IRS still facing backlogs of unprocessed returns and staffing shortages as it copes with its third straight pandemic filing season, experts have warned of significant delays and hurdles for filers. Many of the problems come from two multibillion-dollar pandemic-related relief provisions over the last two years — the advance child tax credit and a pause on student loan payments. The IRS cautioned on Jan. 30 that letters it recently snail-mailed to taxpayers about the child tax credits may be inaccurate. It urged filers to go to their online accounts at the agency, and not to the agency’s child tax credit portal.

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Amid the snafus, filing an accurate return electronically is the best possible way to avoid delays in refunds. Messing things up and later filing an amended return, which must be on paper, all but guarantees delays, given that they take longer to process. The IRS has an updated list of taxpayer frequently asked questions here, but the agency cautions that its answers “will not be relied on or used by the IRS to resolve a case.”

By the time it’s filing season, there are substantially fewer things that a taxpayer can do to buffer tax bills from the prior year. All four moves above, said Todd Jones, the chief investment officer at Gratus Capital, a boutique wealth management firm in Atlanta, are in advisors’ tool kits.