U.S. Government Looking to Ban Individuals from Using the “Back Door”

A few years ago around tax time we received a call from a concerned client regarding his projected tax bill. He was quite confused when he relayed to us that his tax-preparer explained an unexpected tax liability was due to previous year’s Roth IRA conversions. We were surprised to hear this as the conversions in question came from non-deductible IRA contributions . Through careful planning, we had been performing a strategy known as a “Back Door” Roth IRA Contribution.
These clients had been earning too much money to be able to contribute to the Roth IRAs directly, so we made the election to utilize the “Back Door” strategy, contributing on an after tax basis to IRAs and later converting without any tax due. Unfortunately not all tax preparers are aware that this can be done. The IRS and Congress is definitely aware that many are using this loophole and wish to close it by the end of the year, however.
The “Backdoor” Roth IRA Is Currently in the 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.  One of the provisions of the “Build Back Better Bill” is to disallow the conversion of all after tax amounts. This would eliminate a strategy that in one case, allowed us to save a client over $60,000 in taxes on a botched conversion For more on this please refer to this Wall Street Journal Article link.

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. Unfortunately, this may be the last year to do so.

Paying Attention to the Details

We had been making these non-deductible IRA contributions for both the husband and the wife for several years 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, we learned they had not included the Form 8606 for non-deductible IRA contributions on the current return.

While many high income earners are excluded from making direct Roth IRA contributions 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.

The “Build Back Better Bill” is looking to eliminate not only these “Back Door” Roth contributions but also the conversion of after tax amounts in 401ks and IRAs from years gone by. Some have been able to contribute additional lumps into 401ks as after tax contributions in recent years and convert much more than the IRA limit of $7000 per year per person by using these “Mega Back Door Roth’s” in 401ks in recent years. Considering this may be the last year to take advantage of the conversion of these after tax contributions, we want to make sure that everyone is aware, reviews these 8606 forms to make sure they convert everything possible, and do this in the most efficient way, before it is too late.

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 someone has pre-tax IRAs worth $200,000 along with $5,500 in non-deductible IRA contributions prior to making a conversion. Of the $205,500 in total IRA balance 97.3% is pre-tax and 2.7% is after-tax. Even if they convert only $5,500, the conversion will be 97.3% taxable and 2.7% tax-free. So in essence, they will pay ordinary income tax on $5351.50 and only $148.50 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 roll over 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 nondeductible IRA to a Roth IRA allows for a potentially tax-free conversion.

But, it is important to be aware that this year may be the last year to do so.

Backdoor Roth IRA Checklist
  1. Verify there are no other pre-tax IRAs.
  2. If there are, rollover existing pre-tax IRAs to a 401(k) (if available) to avoid the IRA aggregation rule
  3. Contribute to non-deductible IRA.
  4. Invest funds in the non-deductible IRA
  5. Keep invested for up to 1 year.
  6. Convert to Roth IRA
  7. File IRS Form 8606 in the year any non-deductible contributions are made.
  8. Repeat steps annually as desired
Joe D. Franklin, CFP is Founder and President of Franklin Wealth Management, and CEO of Innovative Advisory Partners, a registered investment advisory firm in Hixson, Tennessee. A 20+year industry veteran, he contributes guest articles for Money Magazine and authors the Franklin Backstage Pass blog. Joe has also been featured in the Wall Street Journal, Kiplinger’s Magazine, USA Today and other publications.

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