Last year around tax time I received a call from a concerned client regarding his projected tax bill. He was quite confused when he relayed to me that his tax-preparer explained the unexpected tax liability of close to $5,000 was due to he and his wife’s previous year’s Roth IRA conversions of $13,000. I was also surprised to hear this as the conversions in question came from non-deductible IRA contributions amounting to $13,000 they had made earlier in 2015. Through careful planning, we had been performing a strategy known as a "Backdoor" Roth IRA Contribution.
With this client, we had been performing non-deductible IRA contributions for he and his wife since they became clients in 2009 in order to save additional funds on a tax-deferred basis as they were already maximizing 401(k) contributions. Once the income limitations were abolished on Roth Conversions in 2010, we began converting these non-deductible IRA contributions to Roth IRA’s with little taxes due on the conversion. Neither the client nor his wife had any IRA’s outside of the non-deductible IRA’s, so this wasn’t complicated by what is known of as the IRA Aggregation Rule which will be explained later. Upon contacting their tax preparer about the Roth conversion in question, I learned they had not included the Form 8606 for non-deductible IRA contributions that were made and converted in 2015 on the current return. I explained the situation to the CPA and he was able to complete the Form 8606 for the previous contributions to show that most of the $15000 that was converted should have been tax-free. Only the difference between what they had both contributed (13,000) and what was converted ($15,000) or about $2,000 was taxable as income for them.
While many high income earners are excluded from making direct Roth IRA contributions (single individuals with modified adjusted gross income above $133,000 or above $196,000 for married filing jointly.) they are often able to make non-deductible IRA contributions and later convert these accounts to Roth IRA’s without any taxes due on their non-deductible contributions. Any growth in value will be taxed as ordinary income at the time of the conversion. It is important to note that you must keep track of these non-deductible IRA contributions via timely filing of the Form 8606 with the IRS in the year of the contribution.
Watch out for the IRA Aggregation Rule and Pro-Rata Taxation
There is one other caveat to ensure the conversion is tax-free, the owner should not have any other IRA’s at the time of the conversion. If other IRA accounts exist (includes SEP IRA’s and Simple IRA’s but does not include any IRA’s owned by the spouse) then the conversion will be subject to IRA Aggregation and pro-rata taxation of the conversion. To illustrate this, let’s suppose I had a pre-tax IRA worth $67,000 along with $5,000 in a non-deductible IRA prior to making a conversion. Of my $72,000 in total IRA balance 93% is pre-tax and 7% is after-tax. Even if I convert only $5,000, the conversion will be 93% taxable and 7% tax-free. So in essence, I will pay ordinary income tax on $4650 and only $350 will be tax-free at the time of the conversion.
Using Your 401(k) or Employer Sponsored Plan to Avoid the IRA Aggregation Rule
Those that have IRA’s already may still be able to take advantage of this through proper planning. Since only IRA’s (Traditional, SEP & Simple) are subject to IRA Aggregation, 401(k)’s, 403(b)’s, Profit Sharing Plans, etc. are not included in the calculation. If your employer allows rollovers into their plan, you can rollover any other IRA’s into your plan at work. 401(k)’s and other like plans will only allow pre-tax contributions to be rolled in. This would allow you to convert only the non-deductible IRA to a Roth IRA allowing for a potentially tax-free conversion.
Could “Backdoor” Roth IRA Contributions Get Caught in IRS Crosshairs?
For the time being, the Backdoor Roth IRA is a legitimate strategy for many high earners to get money into after-tax accounts. Some financial advisors and tax experts have pointed out the potential for such transactions to be disallowed in the future. Under what is referred to as “Step Transaction Doctrine”, the Tax courts have ruled previously that transactions performed in rapid succession with no business purpose could incur further scrutiny and be deemed impermissible. In order to protect against such a transactions being disallowed due to potential scrutiny in the future it is advisable to allow any non-deductible contributions an incubation period of at least one month prior to performing the Roth Conversion.
Using non-deductible IRA contributions and later converting into Roth IRA’s while paying little to no taxes can be a worthwhile strategy for those that would like to access Roth IRA’s but are currently restricted from making direct contributions due to their earnings. Implementing such a strategy should only be considered upon consulting with a qualified tax and/or financial professional.
Backdoor Roth IRA Checklist
Verify there are no other pre-tax IRAs.
If there are, roll over existing pre-tax IRAs to a 401(k) (if available) to avoid the IRA aggregation rule
Contribute to non-deductible IRA.
Invest funds in the non-deductible IRA
Keep invested for up to 1 year.
Convert to Roth IRA
File IRS Form 8606 in the year any non-deductible contributions are made.
Repeat steps annually as desired
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