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For years, the U.S. tax code has given high earners a way to get around income restrictions placed on tax-advantaged retirement accounts. The so-called backdoor Roth, or Roth conversion, is an established method of moving money into investments that can grow tax-free.
But that back door may soon slam shut. One proposal released this week would put an end to backdoor Roths as part of a massive Democratic domestic policy bill. The change would take effect next year.
The increased attention comes amid high-profile examples of how wealthy people have used retirement provisions to create staggering gains. A ProPublica report in June, for example, described how tech magnate Peter Thiel converted $2,000 into $5 billion that could become tax-free with the help of a Roth IRA.
“When those things start to come out, you have to take some of those threats by Congress seriously,” says Malik S. Lee, managing principal at Felton & Peel Wealth Management in Atlanta.
Lee, a certified financial planner, says it wouldn’t be wise to make decisions based on a draft of legislation that remains under intense negotiation in Washington. But it’s never too soon to think about alternatives.
“These worries of the backdoor going away have been around for years. This is not something new,” Lee says.
If backdoor Roth IRAs were eliminated or faced stricter limits, financial planners say, wealthy investors may want to consider alternatives, including health savings accounts, life insurance policies and more traditional investment or retirement accounts.
What are backdoor Roths?
There aren’t many retirement savings options that carry the same tax benefits for high earners as the backdoor Roth because it provides access to savings that were originally targeted toward the middle class.
Unlike with traditional IRAs, contributions to Roths are in after-tax dollars. But the money in the account can appreciate tax-free, and it can be cashed out tax-free once the account holder reaches age 59 1/2.
The original laws governing Roths closed them off to high earners. This year, for example, non-backdoor Roth IRA contributions are limited, for single taxpayers, to those making $140,000 or less.
But a change that became effective a decade ago made an exception: People who put money into traditional retirement accounts, then convert them into Roths, (often incurring a big tax bill in the process) can do so without any income limits.
“If this opportunity ends, then you’ve got fewer strategies available to you,” says Greg Geisler, a clinical accounting professor at Indiana University’s Kelley School of Business.
Alternatives to backdoor Roths
If Congress makes changes that put backdoor Roth IRAs out of reach, there are a handful of ideas that personal finance pros present that could replicate some of the benefits. But each has its drawbacks when compared with the current system.
Health savings accounts
For people who have high-deductible health care plans, health savings accounts, or HSAs, are a way to put tax-free money aside to pay for medical expenses not covered by their insurance. And these accounts are some of the most tax-advantaged options available anywhere, experts say.
“I don’t think the average American is really utilizing the benefits of the health savings account like they could be,” says Ashton Lawrence, a certified financial planner and partner with Goldfinch Wealth Management in Greenville, S.C.
Unlike with Roth IRAs, people can make before-tax contributions to health savings accounts. But like with Roths, the money can grow tax free, and it can be withdrawn tax-free — though in this case only for qualified expenses related to care.
Employers often match contributions to health savings accounts.
Though there is a 20% additional tax penalty for withdrawals for purposes other than health care, that cost is waived for account holders who become disabled or are over 65.
The maximum that an employee and employer together can contribute to a health savings account this year is $3,600 for an individual and $7,200 for a family.
Account holders must have high-deductible health plans, which aren’t offered by all employers and may not be right for everyone.
Cash-value life insurance
Permanent life insurance policies have a savings component that can be valuable to their owners even while they’re still alive. And some of the benefits mirror those offered by the Roth IRA.
But Lee cautions that there’s a reason so many people turn to Roths. These life insurance policies are much more complex.
The money in a permanent life insurance policy can grow tax-deferred.
Holders can also take out loans against the value of their policy, and the proceeds of those loans are also not taxable.
Cash-value life insurance policies are not built as retirement savings vehicles. Because of their relatively complex structure, Lee says, costs can be higher.
Policyholders who take out loans against their policies must repay them if they want to maintain their expected death benefit. Lee says anyone looking to make such a transaction should carefully consult their insurer about what it means for the sustainability of their policy.
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Other options, conventional and exotic
There are other backdoor Roth IRA alternatives that could work for some people. Lawrence suggests people who own businesses might want to consider a cash balance retirement plan on top of a 401(k). Such an arrangement can allow much higher contributions than traditional IRAs.
But he says the utility of such a plan is heavily dependent on the specifics of a company, its ownership, its cash flow and its workforce.
Another option is to see whether you’re contributing the maximum amount allowed under retirement savings plans offered through your employer.
And if your primary goal is to grow your money long-term, traditional investment accounts can still provide attractive returns. Even if these investments are subject to capital gains and other taxes, there are strategies to limit your tax burden.
“The most important piece for everyone is just going to be being diligent about saving,” Lawrence says.