In 2010, the income limits applicable to Roth IRA conversions were removed. Since then, higher-income individuals who aren’t eligible to make Roth contributions have had the ability to make an indirect (backdoor) contribution instead.
How To Convert A Non-Deductible IRA
If the front door is closed, why not check and see if the back door is still open? The basic concept of making a backdoor contribution is pretty straightforward. Direct Roth IRA contributions are limited for higher-income taxpayers, since a married couple with an AGI in excess of $194,000 (or $132,000 for an individual) will see their contribution limit reduced to zero. However, anyone with earned income is permitted to contribute to an IRA.
Any traditional IRA account holder is eligible to perform a Roth conversion. While income limits do apply to Roth contributions, there are no such restrictions for a Roth conversion. Therefore, high-income individuals who can’t make Roth IRA contributions can skirt the income thresholds by making a non-deductible IRA contribution – and then convert it to a Roth. There are some important caveats, however, to consider in executing this strategy:
Avoiding The IRA Aggregation Rule
The IRA aggregation rule, under IRC Section 408(d)(2), stipulates that multiple IRAs owned by one individual will all be treated as a single account with respect to the tax consequences of any distributions. This is problematic for those individuals who already have IRA accounts and wish to use the backdoor Roth strategy.
When doing an IRA distribution, after-tax contributions will be distributed along with any pre-tax assets on a pro-rata basis, and when all accounts are aggregated together, it’s impossible to only convert the non-deductible IRA. Therefore, only a portion of the non-deductible contributions can actually be converted.
The IRA aggregation rule only combines an individual’s traditional IRA accounts for tax purposes. Therefore, Roth, inherited, and spousal IRAs, as well as any employer retirement plans – such as 401(k) or profit sharing plans – aren’t included in the aggregation rule. However, SIMPLE and SEP IRAs – which are fundamentally individual retirement accounts – are included.
Avoiding The Step Transaction Doctrine
The step transaction doctrine stipulates that the Tax Court can look at separate steps of a transaction – and if they conclude that there was no legitimate business reason to separate them – can treat them as a single, integrated tax event. This means that if the separate steps of non-deductible IRA contributions and subsequent conversions are completed in rapid succession, the IRS may determine that the intent was to make an un-allowed Roth contribution, and disallow it. Since the step-transaction doctrine is largely applied on a case-by-case basis by the IRS and the courts, it can be difficult to determine whether or not a particular transaction will be considered a step transaction in advance.
So what’s the ideal period of time to wait before converting a traditional IRA contribution to a Roth? There really is no right or wrong answer here, but more time is always safer. Putting more time and space between the steps clearly establishes that the transactions were independent of one another, and not part of a single whole. This makes it easier to claim that the end result of dollars in the Roth account wasn’t due solely to a desire to avoid the rules. As a general rule, it’s a good idea to wait at least one year before converting.
Accumulating The Excess Contribution Penalty Tax
By now, you may be wondering just what running afoul of the step transaction test might mean for you. A backdoor Roth contribution made years ago can still create additional liabilities. While it may be too late for the IRS to challenge an original backdoor Roth contribution that was made in the distant past, the subsequent years – during which the disallowed contribution remained in the account – would still be within the statute of limitations. You would therefore be treated as having made an excess Roth IRA contribution, which would be subject to a 6% annual excess contribution penalty for each year the contribution isn’t corrected.
The Right Way To Do A Backdoor Roth IRA Contribution
- Verify that there are no other pre-tax IRAs.
- If there are any, roll over your current pre-tax IRAs to a 401(k) – if available – in order to avoid the IRA aggregation rule.
- If you’re eligible, contribute to a non-deductible IRA, and invest the funds.
- Stay invested for at least a year.
- Convert to a Roth IRA.
- Repeat steps 2-4 annually, as desired.
The information herein is general in nature and should not be considered insurance, legal or tax advice. Please consult with an insurance legal or tax professional for additional information on specific situations.
Investment advisory services provided by Werba Rubin Wealth Management, LLC (“Werba Rubin”). Securities transactions are offered through a non-affiliated entity, Loring Ward Securities Inc., member FINRA/SIPC. WR 16-044