Back Door Roth

Roth IRAs have always been an attractive retirement savings vehicle, especially if you expect to be in a higher tax bracket in retirement. While you don’t receive any preferential tax treatment in the year you make contributions, qualified withdrawals of your principal and accumulated earnings come out free of any income taxes. The contribution limits for 2017 has remained the same at $5,500 a year, however those 50 and older may contribute an additional $1,000, or $6,500 for the year.

Unfortunately, due to filing status and income limitations, not everyone is allowed to make a direct contribution to a Roth IRA. In 2017, married people filing jointly, maximum Roth IRA contribution amounts are reduced when their modified adjusted gross income (MAGI) reaches $186,000, and then they become ineligible when their MAGI reaches $196,000. For single filers, the phase out limit begins at $118,000 and ineligibility begins at $133,000.

What Is A “Back Door” Roth Contribution?

High income earners can still benefit from Roth IRAs by making what is referred to as a “back door” Roth IRA contribution. Because they are ineligible to make a direct Roth IRA contribution, they instead make a non-deductible IRA contribution and then later convert those non-deductible IRA contributions into Roth IRA assets.

It sounds so simple, however the IRS has rules in place to prevent abusive tax strategies. A couple of things to be aware of are The Aggregation Rule and The Step Transaction Doctrine.

Barriers To The Strategy

The IRA Aggregation Rule under IRC Section 408(d)(2) basically says that when an individual has multiple IRAs, they will all be treated as one account when determining the tax consequences of any distributions. So what does that mean exactly? If you have existing IRAs made with pre-tax contributions, old 401(k) rollovers, and another IRA with non-deductible IRA contributions, any distributions of after-tax assets come out along with pre-tax assets on a pro-rata basis. This means you cannot convert just the new, non-deductible IRA. This can limit the effectiveness of this strategy however if you’re lucky enough to have an employer retirement plan that accepts incoming rollovers, you are able to roll over the entire portion of your IRA that is pre-tax and then the remainder that is non-deductible can then be converted to the Roth since employer plans are not included in the Aggregate Rule.

Perhaps the biggest hurdle is the “Step Transaction Doctrine.” This effectively says that even if a back door conversion would otherwise be legal, it is not permissible for high-income earners to make IRA contributions and subsequent Roth IRA conversions as part of an integrated strategy and with that can come a 6% excess contribution penalty. Each step (the contribution and the subsequent conversion) needs to be handled as separate and distinct transactions. The best way to avoid this is to allow some time to pass between the steps so it does not appear they were intended to be one transaction, although just how much time is debatable but a good rule of thumb is to wait at least a year.

To find out whether making a back door Roth IRA contribution is right for your portfolio and financial situation, consult your financial advisor or tax professional.

Disclaimer: I am a CERTIFIED FINANCIAL PLANNER TM (CFP®), but I am not your CFP® or financial advisor. The information in this article is for general informational and entertainment purposes only and does not constitute financial advice. This article does not create a financial planner-client relationship. The author is not liable for any losses or damages related to actions or failure to act related to the content in this article. If you need specific financial advice, consult with a licensed financial advisor, CFP®, or tax professional who can tailor advice regarding your specific circumstances. Additionally, sometimes I use affiliate links to support my website. This means I may earn a small commission, which is no additional cost to you, for referring and discussing products and services that I personally use, or have used and trust. Thanks for your support!