Much like teenagers sneaking out through the back door, this Roth conversion strategy isn’t as sneaky as we would like to think. The strategy has come in the crosshairs of government regulators recently. While we don’t know if it will be discontinued, we thought it might be interesting to illuminate what this strategy involves, as we see it in the financial news headlines more. A backdoor Roth conversion, as it has been nicknamed, is essentially taking advantage of a loophole in the ROTH contribution and conversion rules.
Many people are aware of the potential benefits of contributing to a Roth IRA. The main advantage being tax-free withdrawals after you have reached the age of 59 ½ and having held the account for five years or more. Tax-free growth, tax diversification in retirement, and passing money on tax-free to heirs are other advantages of the Roth. However, your ability to contribute to a Roth IRA is determined by your annual modified adjusted gross income (MAGI). For example, the IRS limit for 2015 phases out at $193,000 MAGI for married couples who are filing jointly; so for those reporting MAGI over the limit, direct Roth IRA contributions are not allowed.
On the other hand, Roth conversions are available to all income levels regardless of MAGI. The loophole works like this: high-income earners make a non-deductible IRA contribution, which is $5,500 for 2015 plus a $1,000 catch up contribution for those ages 50 and older. The non-deductible IRA contribution is then converted to the Roth IRA, since there are no limits on who can convert. The end result is a Roth IRA.
If you do not convert right after you make the IRA contribution, you might owe tax on any earnings that the account generates prior to the conversion. It is also important to note that if you already have other IRAs, this strategy becomes more complex. The IRS requires that you take into account all of your IRAs when you are converting assets to a Roth under the pro-rata rule. This means that you may owe tax on a portion of the amount converted and you would have a portion of basis to track throughout your other IRAs. That makes it messy.
We have seen this strategy work well for high income individuals with no other IRAs – basically all of their retirement savings are in their employer qualified plans, such as their 401k. Only other IRAs count towards the pro-rata rule. Considering it is a “loophole”, there has also been discussion as to whether the IRS might disallow it as a step transaction. You can see how this could be a complicated strategy, so it is important to work with your tax advisor and financial advisor to ensure that this is an appropriate strategy for your unique situation.
Kim Butler, CFP®
Associate Financial Planner