Backdoor Roth IRA – A Smart Move for Some Taxpayers

July 20, 2017 / Article, Investments

A Roth IRA is a distant cousin of the traditional IRA. They have similar names but there are distinct differences.

The benefits of a Roth IRA

In contrast to a traditional IRA, contributions to a Roth IRA are not tax deductible, however all earnings and withdrawals from a Roth are tax free and there are no minimum required distributions from a Roth during the lifetime of the original owner. As a result, Roths are a particularly good way to save for retirement or for the benefit of heirs.

Individuals can contribute 100% of their earned income, up to $5,500 ($6,500 for those over 50) to either a Roth or traditional IRA, although those over 70-1/2 years old cannot contribute to a traditional IRA. Contributions to a Roth IRA are limited to those with a modified adjusted gross income (MAGI) below $133,000 for single individual and $196,000 for those filing jointly.  Income limitations are even lower for a traditional tax-deductible IRA

The income limitation presents a problem for some taxpayers who would like to contribute to a Roth since those with incomes above the limitations are not eligible to contribute to either a Roth or a traditional tax-deductible IRA. In contrast, there are no income limits for contributing to a non deductible IRA.

The Workaround

Since there are no income limitations on the conversion of a non-deductible IRA to a Roth IRA, that opens a “back-door” for taxpayers who exceed those income limitations. Specifically they may first make a contribution to a non-deductible IRA and then convert this to a Roth.  If the taxpayer has no other traditional IRA’s the only tax due is from any gain on investments in the non-deductible IRA before it is converted to a Roth.

It is possible for an individual to do a “backdoor” Roth contribution every year and build up a reasonable sized Roth IRA which will never be taxed.

Caveats

One important caveat is that if the taxpayer also has traditional pre-tax IRAs, then IRS “pro-rata” rule limits will result in taxes on the conversion. This means that the IRS looks at the total of all your IRA’s combined and the proportion of that money that has not yet been taxed.  For example, if you have a combined total of $100,000 in both traditional deductible  and non-deductible IRA’s, and $75,000 (75%) of that is in traditional tax deductible IRA’s, then 75% of any conversion will be taxed.

Yet, if the taxpayer’s 401K plan allows, it may be possible to move traditional IRA’s to their 401K plan and then contribute to a non-deductible IRA and subsequently convert the non-deductible IRA to a Roth IRA.

A second caveat is that the Tax Court recognizes a “step transaction doctrine” which rules that separate transactions, even if legally done, can be viewed as a single integrated transaction. To minimize the possibility that the IRS would take that position and disallow the Roth conversion, most experts recommend allowing a reasonable amount of time between contributing to a non-deductible IRA and the subsequent conversion to a Roth and consulting a tax expert.  While most tax experts are hesitant to specify a specific period of time, occasionally a period of six months or longer is mentioned.

The Benefits Can Justify the Inconvenience

Although having to use the “backdoor “is not particularly convenient, the benefits of contributing to a Roth are significant. Under current tax laws, a Roth will never be taxed and since there are no minimum distributions required during the owners lifetime, the entire amount can be passed down to beneficiaries after death and not be subject to income taxes.

Of course IRS rules are always subject to change, so it is not possible to determine how long this opportunity will continue to exist. 2017 is especially uncertain since tax reform is a top priority of the current administration.


About the author

John Eckel: CFP®, CFA is President of Pinnacle Investment Management Inc. of Simsbury. He has been included in BusinessWeek.com’s list of the Most Experienced Independent Financial Advisors, has been named four times to Worth Magazine’s list of Top Financial Advisors, included twice in Medical Economics list of Top Financial Advisors for Doctors and named twice in JK Lasers list of Top Professional Advisors for Baby Boomers.