Democrats want to cut way back on those backdoor Roths – Yahoo Finance

Funding a Roth IRA through the backdoor has been a favorite move of aggressive savers in recent years.

But the benefit may be much less prevalent if Democrats pass their ambitious multitrillion-dollar budget reconciliation bill.

The backdoor Roth maneuver lets a high-income earners contribute money to a traditional IRA and then convert it into a Roth to skirt income limitations in the Roth program, but still take advantage of the tax benefits. Once the move is made and the relevant taxes are paid upfront the retirement account can grow and won't be subject to taxes again (earnings can grow tax-free, and qualified withdrawals are tax- and penalty-free).

[Cashay: Everything you need to know about IRAs]

The Democrats' plan, however, would scale back Roth conversions, and completely eliminate the ability for the richest Americans to convert traditional IRAs into Roth IRAs by 2032. Right now, individuals with an income above $140,000 are not permitted to make Roth IRA contributions directly. The change would mean that wealthier Americans individuals with a taxable income over $400,000 or couples filing jointly with taxable income over $450,000 wouldn't be able go through the backdoor to make a conversion.

A related maneuver called the mega backdoor Roth IRA would be eliminated even sooner. This move allows employees in certain retirement plans make an after-tax contribution to their 401(k) that they then roll into a tax-protected Roth. That move would be eliminated by 2022 and apply to everyone, regardless of income level.

A "backdoor" Roth IRA is a way for high-income taxpayers to fund a Roth, even if their incomes exceed the limits that allows for regular Roth contributions. (Getty Images)

Gordon Gray, director of fiscal policy at American Action Forum, a Washington think tank, notes that the drive to limit Roths is based on a few very visible cases of this in the news, but predicts the bill, if enacted, would raise only a little over $4 billion over the coming decade a drop in the bucket in the proposed $3.5 trillion package.

I think this is a little bit of policy chasing headlines, says Gray.

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The headlines in question surround a blockbuster ProPublica story published this summer that found billionaire Peter Thiel, a founder of PayPal (PYPL) and an early investor in Facebook (FB), was sitting on a Roth "individual retirement account" worth $5 billion.

Thiel and other ultra-wealthy Americans, the investigation found, have turned their Roths into supercharged investment vehicles subsidized by American taxpayers. They'll pay no taxes on the returns on their investments if they wait to access the money until they're 59 1/2.

IRAs have been in the political crosshairs before, notably in 2012 when then-presidential candidate Mitt Romney was reported to have a traditional SEP-IRA worth $102 million. While Thiel and Romney used a variety of tricks, the backdoor provisions were reportedly not a key way they amassed their IRA fortunes.

The people that do these types of [backdoor] strategies are not very, very wealthy, super high-income earners that are trying to skirt paying taxes that they owe," said Henry Yoshida, co-founder and CEO of a self-directed IRA company called Rocket Dollar. "Instead, they are very financially responsible people with actually more mid-tier incomes that live pretty well below their means.

Entrepreneur Peter Thiel participates in a discussion at the National Press Club on October 31, 2016 in Washington, DC. Thiel discussed his support for Republican presidential nominee Donald Trump. (Photo by Alex Wong/Getty Images)

Another change proposed by Democrats could target a future Peter Thiel more directly. The tax plan would ban IRAs from making certain types of investments, even if the account holder has a specific license to do so. According to a summary, the bill prohibits IRAs from holding investments which are offered to accredited investors because those investments are securities that have not been registered under federal securities laws.

According to the ProPublica investigation, Thiel achieved his eye-popping balance by purchasing his founders shares in PayPal through his Roth IRA during PayPals formation. It was an investment not available to the general public, and an example of one that would likely be disallowed under the Democrats' new rule.

Other changes in the plan dont address Roth accounts directly but are designed to bring in additional revenue from the wealthiest Americans and their retirement plans. One proposal would add a contribution limit for retirement plans of high-income earners with account balances over $10 million. Another would institute an increase in minimum required distributions for high-income earners with similarly large account balances.

Former U.S. Senator William Roth Jr. represented Delaware for decades and pushed provisions into the Taxpayer Relief Act of 1997 to create his namesake account type. A little over decade later, further changes allowed Roth conversions for anyone regardless of income level beginning in 2010.

Yoshida noted that in recent history Washington actually really loved Roth IRAs because they got tax revenue today from people that had the means and qualified to do so.

House Ways and Means Committee Chairman Richard Neal (D-MA), right ,is spearheading the Democrat's tax plan in the upcoming reconciliation package. (REUTERS/Joshua Roberts)

All of a sudden now, I think that they're maybe prematurely looking at eliminating [the provisions] based on a very extreme edge case, he said, adding that he doesn't think the provisions "are actually going to penalize the people that you're intending to penalize.

But in the end, Congressional observers like Gray expect the new Roth provisions to become law if Democrats are able to muscle the massive package through Congress.

The revenue raised by the new rules, however small, will help fund the rest of the bill.

I expect those will stay in, in part because it does raise money, said Gray, a former advisor to lawmakers including Sen. Rob Portman and Sen. John McCain. Because Democrats are going to want to hold onto as many of the offsets that they can, and given the visibility on some of these, they probably feel pretty strongly about being able to defend these changes, he said.

Ben Werschkul is a writer and producer for Yahoo Finance in Washington, DC.

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Democrats want to cut way back on those backdoor Roths - Yahoo Finance