With April 15th just behind us, many investors consider using tax refunds to bolster retirement savings. Roth IRAs are a great way for many investors to grow their retirement nest egg free of tax implications. Unfortunately, the ability to contribute directly to a Roth IRA is phased out for high income earners. In 2019, the ability to contribute directly begins to phase out starting at $122,000 for individual filers and completely phases out at $137,000. For married couples, the ability to contribute directly begins to phase out starting at joint-income levels of $193,000 and completely phases out at $203,000. Fortunately, there’s still a way to still a way to contribute to a Roth IRA for those subject to the phase out of direct contributions by the income limits.
A “backdoor” Roth IRA contribution, at its simplest, involves making a contribution to a traditional IRA using after-tax dollars and then performing an immediate tax-free Roth conversion. In 2010, income limits on Roth IRA conversions were removed, opening the backdoor for Roth IRA contributions by investors at any income level. Fortunately, recent changes to the tax code do not appear to have an impact on the ability to perform a “backdoor” maneuver.
There are two main caveats to implementing a backdoor Roth strategy.
First, the backdoor Roth strategy becomes complicated when an investor currently has assets in a Traditional IRA funded with pre-tax dollars. Since contributions to a Traditional IRA are typically done pre-tax, the IRS will want to collect tax on any Traditional IRA conversions using pre-tax dollars. Making an after-tax contribution to a traditional IRA that’s already funded with pre-tax contributions will result in a pro-rata tax bill on the pre-tax assets subject to conversion. For example, consider an investor that has $45,000 pre-tax dollars in a traditional IRA and then makes a $5,000 after-tax contribution. If that investor decides to make a $5,000 Roth conversion, 90% of the conversion (or $4,000) would be taxable immediately. However, this problem disappears when all assets in a Traditional IRA are funded with after-tax dollars.
Second, a backdoor contribution to a Roth IRA could potentially violate a judicial doctrine called the “Step Transaction Doctrine”. The Step Transaction Doctrine postulates that two permitted individual actions, when taken together as a whole action, could be construed as an unpermitted action. Advice for avoiding running afoul of the Step Transaction Doctrine typically involves waiting a specific period of time between contribution and conversion – generally between one month and one year. However, evidence of the IRS actually using the Step Transaction Doctrine to prosecute an investor regarding backdoor Roth contributions is scarce.
Going forward, there’s always the continued chance the backdoor could be closed by new tax legislation. Additionally, as this strategy has particular nuances for each individual, talking about your particular situation with a tax advisor is highly recommended.