Factors To Consider When Contemplating A ‘Backdoor’ Roth IRA

October 17th, 2017

The following originally appeared on Forbes.com and was written by our own Adam Bergman –

There have been no income level restrictions for making Roth IRA conversions since 2010, hence a high income earner can do a conversion of after-tax (non-deductible) IRA funds to a Roth IRA, which is known as a ‘backdoor’ Roth IRA. In other words, the ‘backdoor’ IRA allows a high- income earner, who has exceeded the Roth IRA annual income contribution limits, to circumvent those rules and make a Roth IRA contribution. However, as detailed below, a tax could be due on the conversion under the pro rata (aggregation) rules if the IRA holder has other traditional pre-tax IRAs that have not been taxed. In general, the taxes owed on the conversion will depend on the ratio of IRA assets that have been taxed to those that have not, making the ‘backdoor’ IRA unattractive for some.

A regular contribution to a Roth IRA is generally limited to the lesser of the annual contribution limit or 100 percent of the individual’s compensation. The Roth IRA contribution limit is the same as the traditional IRA limit. For the year 2017, the annual contribution limit for an individual under the age of 50 is $5,500, and $6,500 for an individual over the age of 50.

An individual making Roth IRA contributions must reduce those contributions by the amount of any contributions made to a traditional IRA.  However, not all individual taxpayers are eligible to make Roth IRA contributions.  For taxpayer’s filing as single, one must have a modified adjusted gross income under $133,000 to contribute to a Roth IRA for the 2017 tax year, but contributions are reduced starting at $118,000.  Taxpayers filing as married, the combined modified adjusted gross income must be less than $196,000, with reductions beginning at $186,000.

Before considering a ‘backdoor’ Roth IRA strategy, there are a number of important items to consider.  The first is the concept of the IRA pro rata aggregation rules.  Under Internal Revenue Code Section 408(d)(2), the aggregation rules hold that when an individual has multiple pre-tax IRAs, they will all be treated as one account when determining the tax consequences of any distributions (including a distribution out of the account for a Roth conversion). In other words, the aggregation rules can cause issues for individuals looking to take advantage of the ‘backdoor’ Roth IRA strategy that have multiple IRA accounts.

For example, Amy has $100,000 of existing pre-tax IRA assets across multiple IRA accounts. Amy now makes over $200,000 so is not eligible to make a Roth IRA contribution for this year.  Amy wishes to make a $5,500 Roth IRA contribution by taking advantage of the ‘backdoor’ Roth IRA strategy, which involves making a non-deductible IRA contribution and then converting those funds into a Roth IRA.  However, since Amy has $100,000 of pre-tax IRA funds prior to the Roth IRA conversion, the aggregation rules will limit how much Amy can convert to a Roth IRA.

If Amy attempted to do a $5,500 Roth conversion (from combined IRA funds that now total $100,000 plus a new $5,500 contribution that equals $105,500), the return-of-after-tax portion will be only $5,500 / 105,500 = .52%, which means the net result of her $5,500 Roth conversion will be $28.60 of after-tax funds that are converted.  $5,471.14 of the conversion will be taxable, and she will end up with a $5,500 Roth IRA and $100,000 of pre-tax IRAs that still have $5,471.14 of related after-tax contributions. Hence, the net result of the IRA pro rata attribution rules is that a large portion of the after-tax funds linked with the new after-tax IRA contribution will not end up in the Roth IRA and will instead be connected with the existing pre-tax IRA funds.

Based on the example, the IRA attribution rules significantly limited the tax benefit of the ‘backdoor” Roth strategy for Amy as only a very small amount of the $5,500 after-tax funds were able to be converted tax-free to the Roth IRA. In addition, the IRA attribution rules only apply to pre-tax IRAs of the taxpayer, not his or her spouse, inherited IRAs, or any employer retirement plans (i.e. 401(k)), which can offer some interesting tax planning opportunities.

In addition to being mindful of the IRA attribution rules when considering a ‘backdoor’ Roth IRA conversion, one must also consider the step-transaction-doctrine. The step-transaction doctrine, which arose from a Supreme Court case, holds that a court can invalidate a transaction if the separate steps involved in the transaction have no independent substantial business purpose. In the context of the ‘backdoor’ Roth IRA strategy, the thinking goes that if the separate steps of the non-deductible IRA contribution and subsequent Roth conversion are done too quickly or simultaneously there is some risk the IRS could attempt to invoke the step-transaction doctrine in order to invalidate the Roth conversion.

There is no court precedent for this position, but many tax experts believe it would be wise to wait some time in between the nondeductible IRA contribution and the subsequent Roth conversion. There is also no firm rule for how long one should wait after the nondeductible contribution is made before making the Roth IRA conversion, but waiting a few months and having the IRA funds invested during the waiting period is thought to be sufficient.

Since 2010, the ‘backdoor’ Roth IRA strategy has been viewed as an attractive way for many high income earners to take advantage of the power of the Roth IRA.  Below are some tips to consider before doing a ‘backdoor’ Roth IRA:

  • Understand the Roth IRA contribution income limits for the taxable year in question
  • Determine whether you have any existing pre-tax IRA funds. If so, understanding the IRA attribution rules under Internal Revenue Code Section 408(d) is crucial
  • Are you currently participating in an employer retirement plan? If so, rolling over existing pre-tax IRA funds to an employer plan may help you circumvent the IRA attribution rules.
  • Be mindful of the step-transaction doctrine and consider waiting at least several months between the non-deductible contribution and the Roth IRA conversion
  • Consider not documenting that you are doing a ‘backdoor’ Roth IRA strategy.

It is unclear how long the ‘backdoor’ Roth IRA strategy will continue to be permitted. President Obama’s 2016 budget recommendations did attempt to end it, but the recommendation did not become law.  It is unclear what the Trump Administration’s position is with respect to it.  However, for now, the ‘backdoor’ IRA strategy continues to be a very popular way for high income earners to make Roth IRA contributions.

For more information about the ‘Backdoor’ Roth IRA, please contact us @ 800.472.0646.

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