Buried in the footnotes of the Tax Cuts and Jobs Act (TCJA) Conference Report was a boring, but important explanation: No longer will tax professionals debate the legitimacy of contributing to a traditional, non-deductible IRA and immediately converting it to a Roth IRA. Many worried the Internal Revenue Service would disallow the contribution as it violated the step-transaction doctrine; however, footnotes 268, 269, 276 and 277 of the Conference Committee’s explanatory report provided clarity and validated the backdoor Roth IRA contribution. But, before I get too far ahead of myself, let’s pause to review how Roth IRAs work and key points associated with a backdoor Roth IRA contribution.
A Roth individual retirement account is a unique retirement account that may offer income tax benefits and flexibility in your financial plan. These unique retirement accounts have intrigued investors and became very popular since their introduction. Named after Sen. William Roth, the Roth IRA became available to U.S. taxpayers courtesy of the Taxpayer Relief Act of 1997.
Roth IRA has two principal differences from most tax-advantaged retirement plans:
- Distributions from the account are not included in your taxable income, provided distributions are deemed qualified.
- There is no deduction on your income tax return for contributions into a Roth IRA.
The obvious attraction of tax-free growth and tax-free distributions has many financial planners and investors utilizing this special retirement plan. Why wouldn’t everyone use a Roth IRA?
First, you might be foregoing a current income tax deduction by choosing a Roth IRA over a traditional IRA. Second, you generally need earned income, and you need to be eligible to make a contribution.
Below are the income limits for 2018:
Are You Eligible? – Generally, you can contribute to a Roth IRA if you have taxable compensation, and your modified adjusted gross income (AGI) is less than:
- $189,000 for married couples filing jointly, or a qualifying widow(er)
- $120,000 for single, head of household, or married filing separately, and you did not live with your spouse at any time during the year
- $0 for married couples filing separately, and you lived with your spouse at any time during the year
If you meet the criteria outlined above, you are permitted to contribute up to the $5,500 limit. Individuals who are 50 and over can contribute $6,500 per year to “catch up.”
If your modified AGI exceeds the threshold, your contribution limit will be reduced, or you may be ineligible for a Roth IRA contribution altogether. To learn more about modified AGI and IRAs, go here.
Not eligible, now what? If you are not eligible to make a Roth IRA contribution, all hope is not lost. If you are a high-income earner and want to contribute to a Roth IRA, it is still possible; however, it’s a two-step process.
While you may be ineligible to contribute directly to a Roth IRA, Congress enacted a law that opened the “back door” to Roth IRAs. The law, which took effect in 2010, lifted income restrictions on converting to a Roth IRA; therefore, high-income earners willing to take an additional step can place money into a Roth IRA.
The first step is to make a non-deductible traditional IRA contribution. There are no income limitations on making a traditional IRA contribution, as long as the taxpayer is not claiming a deduction.
The second step is to immediately convert the traditional IRA contribution to a Roth IRA. A non-deductible traditional IRA contribution creates cost-basis in the IRA. The cost basis represents after-tax money, and it will not be taxed again when it is converted to a Roth IRA. Thus, high earners willing to take the extra steps can effectively make a Roth IRA contribution.
However, it is not always this easy for every investor. If you have an existing traditional IRA, additional analysis is required – conversions may be fully taxable, partly taxable or nontaxable. Determining the taxable amount depends on how the contributions were made, and how much accumulation of tax-deferred growth (investment earnings which accumulate tax-free until investor withdraws and takes possession of them) has occurred. If only deductible IRA contributions (IRA contributions deducted against your income) or any rolled-over pretax amounts were made to your traditional IRA, you have no cost basis in your IRA. Because you have no basis in your IRA, any conversions are fully taxable. If you made non-deductible contributions or rolled over any after-tax amounts, you have a cost basis. These nondeductible contributions are not taxed when they are converted.
Many investors have a combination of pre-tax and after-tax amounts in their IRA, thus any conversions would be partly taxable. So how much would be taxable? The IRS provides instructions on how to calculate the taxable amount; however, in general terms, each dollar converted will have a prorated cost basis associated with it. While this could be an extremely beneficiary strategy one should consult with their financial planner or tax professional before implementing.
Who are likely candidates to utilize Backdoor Roth contribution?
Investors should consider implementing this strategy if they have all their pretax money invested in an employer-sponsored retirement plan, are contributing the maximum amount to their existing employer-sponsored retirement plan, do not have existing IRA balances and have extra cash flow to invest.
In 2010, when the IRS lifted income restrictions on converting to a Roth IRA, the number of conversions grew rapidly. Many individuals implemented the strategy discussed above; while others were hesitant fearing it would violate the step-transaction doctrine. The recent footnotes buried in Conference Committee explanatory report has added clarity, validating this strategy for individuals and planners to consider.
If you, or anyone you know, would like to learn more about the Backdoor Roth IRA Contribution, please feel free to contact us to discuss more.