May 8, 2019

Roth IRA After TCJA: The Backdoor Is Still Open

As you likely know, the Roth IRA is a terrific way to grow your wealth with a minimum tax downside because you pay the taxes up front, and then with the proper holding period, pay no taxes after that.

Eligible individuals can now contribute a total of $6,000 ($7,000 catch-up for ages 50 and up) each year to either a Roth IRA or traditional IRA.

For the Roth IRA, your ability to make contributions is phased out as your income increases. For 2019, this phaseout occurs when your adjusted gross income (AGI) is between $122,000 and $137,000 (single) or between $193,000 and $203,000 (married filing jointly). If you earn more than the upper limits of the phaseouts, you’re completely barred from contributing to a Roth IRA. But that’s only if you don’t know what you are doing.

Front Door
When your income is above the phaseout, you’re not allowed to go into the Roth IRA through the front door, so to speak, and contribute directly. But there’s a back door that’s still wide open, even after tax reform. You just need to go about using it the right way.

The Backdoor Roth: Basic Steps
Here are the three basic steps:

  • Create a traditional IRA, and make a “nondeductible” contribution. (If you already have a traditional IRA, the nondeductible contribution with the backdoor strategy triggers some taxable income, as you will see below.)
  • Convert the nondeductible traditional IRA to a Roth IRA.
  • Pay the applicable taxes, if any, as we explain below.

Tax-Free Back Door
Example: You (a) are above the threshold and (b) have no existing IRAs. You make a nondeductible $6,000 contribution to a traditional IRA. Tomorrow, or shortly thereafter, you roll over the $6,000 from the nondeductible traditional IRA to the Roth IRA. You now have the Roth IRA in place via the back door, and you incurred no taxes making this backdoor move.

Taxable Back Door
Example. You own traditional IRA #1, which has a value of $12,000, funded entirely with deductible contributions. You create traditional IRA #2 and fund it with a $6,000 nondeductible contribution. You then convert IRA #2 to a Roth IRA.

The IRS looks at all your IRA accounts to determine whether you must pay tax on the conversion, and $12,000 of the $18,000 in your combined IRA funds consists of previously untaxed money. Thus, you will have to pay tax on two-thirds of your contribution ($12,000 ÷ $18,000). This creates taxable income of $4,000 ($6,000 x 2/3). Technically, what happens with the conversion of the nondeductible IRA transfer to the Roth is that the IRS looks at all your IRA accounts and excludes only those monies that are basis.

Note. In the traditional IRA, you make a deductible contribution, and your earnings accrue tax-free until you take them out. You have no basis in either the contribution or the earnings. At this point, all the money in the traditional IRA is untaxed money.

Make the Tax Go Away
The pro rata allocation rule does not include money in qualified plans, such as a 401(k). If you first roll over your traditional IRA into a 401(k) or other qualified plans, you avoid any tax hit when creating the backdoor Roth IRA.

Example. You roll over IRA #1 into your existing 401(k), so you now have no IRAs. Next, you make the nondeductible contribution to a new IRA and then roll that over to the Roth IRA. Presto! No taxes.

TCJA and the Back Door
You may have worried that the Tax Cuts and Jobs Act (TCJA) destroyed the backdoor Roth. Fear not! Not only is the backdoor Roth still viable, but it appears that TCJA lawmakers recognized and blessed the strategy. In footnote 269 of the massive House conference report, lawmakers stated: “Although an individual with [adjusted gross income] AGI exceeding certain limits is not permitted to make a contribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA.”

Also, in an article in Tax Notes titled “IRS Won’t Target ‘Backdoor’ Roth IRA Contributions,” Donald Kieffer Jr., tax law specialist (employee plans rulings and agreements), IRS Tax-Exempt and Government Entities Division, is quoted as saying that the backdoor Roth is “allowed under the law,” even though “I don’t think you’ll find any specific legal or IRS guidance that says that.”

Step Transaction or Not
Some tax writers worry that the backdoor Roth could be undone as a type of step transaction, because the steps enable you to do something indirectly (contribute to a Roth) that you are not allowed to do directly, due to income limitations.

Writers who have this concern (which we do not share) suggest that you can avoid the step transaction by putting time between the nondeductible contribution to the traditional IRA and the rollover to the Roth. This worry group says that the more time between the transactions, the less worrying you need to do.

If you are a high earner and you want to have a Roth IRA, you can use the backdoor Roth technique, which involves making a nondeductible contribution to a traditional IRA and then rolling that money into a Roth. The backdoor Roth strategy has been around for a good nine years, and it has experienced no trouble that we are aware of, so we think it’s a good strategy. We also like the recent notations in the legislative history and the comments from the IRS spokesperson that show approval of the strategy.

Keep in mind that with some planning, you can avoid any taxes on the rollover. For example, if you have an existing traditional IRA, you can move those monies to your qualified plan to avoid having the backdoor strategy trigger some taxes. And if you have no traditional IRA, the nondeductible contribution to the traditional IRA and the subsequent rollover to the Roth IRA triggers no taxes.

Investing your IRAs is a common practice to grow the tax benefit long term. You should seek out the advice of a financial planner before making investment decisions.

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