I was recently chatting on Facebook with my cousin who is a successful financial advisor, and we were discussing the “backdoor” Roth IRA conversion. The backdoor Roth IRA conversion is a strategy that allows some high income earners who participate in employer sponsored retirement plans to also make indirect contributions into a Roth IRA, in spite of IRS contributions limits. The way the backdoor strategy works is you make a non-deductible contribution to a traditional IRA and then immediately convert it to a Roth IRA. Sounds pretty easy right? Unfortunately, there is a lot of IRS fine print that must be understood before trying this trick at home.
The backdoor Roth IRA conversion is a great strategy for transferring a non-deductible tax-deferred IRA contribution into a Roth IRA if (1) you have no other traditional IRA funds, or (2) the value of your other IRAs are less than or equal to the basis in your IRA accounts. However, very few people own non-deductible IRAs exclusively. Usually, investors will open a deductible IRA first, and then when their employer offers them a better retirement plan, they stop funding their deductible IRAs and begin participating in their employer’s plan. Or, they will rollover a previous employer’s retirement plan into a deductible Traditional IRA when they change jobs.
Later on when the investor’s income is large enough to max out their contributions to their employer plan (as well as disqualify them for a deduction in their traditional IRAs), they pursue investing their supplementary funds into a non-deductible Traditional IRA. The non-deductible Traditional IRA won’t help reduce a current year tax liability, but it will allow investors to defer the taxes on the growth of the non-deductible contributions. Non-deductible IRAs are complex, requiring investors to file an 8606 Form with their taxes, as well as keep accurate records of which contributions were deductible and which were non-deductible. From a tax perspective, funding a non-deductible IRA is easy; however, taking distributions in retirement and accurately paying the taxes on those distributions (some taxed, others not taxed) can be a real pain.
Because non-deductible Traditional IRAs are difficult and Roth IRAs are easy, there is a lot of incentive to replace non-deductible IRAs with Roth IRAs. Initially, Congress disallowed high income earners from participating in Roth IRA conversions; however, in 2010 Roth IRA conversions were made available to everyone regardless of income. As a result, financial planners saw an opportunity for high income earners to participate in Roth IRAs as well. This is where the backdoor conversion came to fruition.
There are two flies in the ointment investors should consider before using the backdoor Roth IRA conversion. Nothing that comes out of Congress is simple or even intuitive, and backdoor Roth IRA conversions are no exception. If you don’t own any Traditional IRAs where you took a tax deduction, no problem. However, if you own ANY Traditional IRAs where the values exceed the contributions you made to the IRAs, you will be subject to the IRA Aggregation Rule under IRC Section 408(d)(2). This rule stipulates that when a Roth conversion occurs, the taxpayer must calculate the income tax consequences of a Roth conversion by aggregating together all of the taxpayer’s IRAs; therefore, if you own any other Traditional IRAs, they will complicate the tax consequences of the “contribute-then-convert” strategy. For example:
Assume Steve contributes $5,500 to a non-deductible IRA with the intention of converting it to a Roth IRA. However, Steve also has a $100,000 IRA funded from earlier pre-tax IRA contributions and two prior 401(k) rollovers. When Steve converts his newly created $5,500 non-deductible IRA, he cannot simply convert at a tax cost of $0. Instead, the IRA aggregation rule applies as follows: $5500 (all non-deductible IRA contributions/ ($100,000 (all IRA assets) + $5500 (newest non-deductible contribution ) = 5.213% or $286.73. In other words, Steve will have to pay taxes on $5213.27, thus making the conversion about as enjoyable as chewing on tinfoil.
To get around the aggregation rule, some investors choose to roll their existing IRAs with pre-tax contributions into their employer plans. By not having a Traditional IRA with pre-tax contributions, there is nothing to aggregate, thus the annual backdoor Roth IRA conversions are much simpler; however, not all 401(k)s offer investments as robust and diverse as a self-directed traditional IRA; therefore, investors will need to determine if losing their options and flexibility by rolling their Traditional IRAs into their employer’s plan will be offset by the advantages of funding their Roth IRAs annually.
Another consideration is the “Step Transaction Doctrine,” which permits the IRS to disallow strategies such as the backdoor Roth IRA conversion if they can prove the only economic value you received from opening a non-deductible Traditional IRA before converting to a Roth was to avoid the prohibition of funding a Roth IRA directly. The problem with the step transaction doctrine is the IRS applies the rule arbitrarily on an individual basis. That means some people might get away with it, and others might get hammered. There is no way for certain to know if they will use the Step Transaction Doctrine to slap you with a 6% excess contribution penalty sometime in the future after you have been converting for decades and your Roth IRA has grown hefty. Therefore, backdoor at your own peril.
While the backdoor Roth conversion strategy might be a good opportunity, I recommend meeting with your financial planner and tax advisor first to discuss how the aggregation rule and the step transaction doctrine might affect you. With long-term capital gains and dividends currently taxed at 15% for most investors (high income earners will pay more) many clients may prefer investing in a taxable account or real estate with their supplementary investment dollars rather than go through the hassle of a backdoor conversion of non-deductible Traditional IRAs.