Backdoor Roth IRAs have increasingly become more popular over the last few years. The following post is the second part in a two part series of blog posts that are dedicated to helping readers understand what exactly a Backdoor Roth IRA strategy entails, what are the pitfalls to avoid, and what type of investors would benefit from this strategy. For those that have not yet read part 1 of this series of posts, I would suggest reading that post first before reading this one.
Part 2 - Things to Avoid and a Word of Caution Before Initiating a Backdoor Roth Conversion
IRA Aggregation Rule
When contemplating whether a backdoor Roth IRA would be an appropriate strategy for you, the most important thing that you first should take note of is the aggregation rules of IRAs. The IRA aggregation rules state that when an individual has multiple IRA accounts (Traditional IRAs, along with SEPs and Simple IRAs), for conversion purposes, all of these accounts are considered one large account. In these cases, the individual cannot say that he/she solely wants to convert his IRA to a Roth from the nondeductible portion of his/her IRA accounts, rather the conversion will be done on a pro rata basis, comprised of both deductible and nondeductible portions based on the overall percentages that are in each across ALL of the individual's IRA accounts. The portion that will be converted from the deductible IRA portion will be taxed as ordinary income in the year converted.
For example, let’s say that Fred has $450,000 in Traditional IRAs that he has accumulated due to deductible IRA contributions he made over the years, growth inside the deductible IRA accounts, and assets that he rolled over from his old 401(k) plan. Fred is over the MAGI limits to make a direct Roth contribution, so he decides he wants to make a backdoor Roth contribution. He makes a nondeductible contribution of $5,500 to an IRA account. When he goes to convert that $5,500 into a Roth account, he has a total of $455,500 ($450,000 deductible, $5,500 nondeductible) across all of his IRA accounts with only 1.2% (5,500/450,000) in nondeductible IRAs. Thus, of the $5500, only $66.41 (1.2% of $5500) would not be considered a taxable conversion, the remaining $5,433 would be taxed as ordinary income. You could see how having to pay income taxes on money that has already been taxed is not optimal, thus Fred might either need to rethink going through with the backdoor Roth strategy or find ways to reduce the effects of the aggregation rules on the transaction (see next section).
It should be noted that the IRA account aggregation rule applies to each person individually and not to a married couple combined. Thus, if in the above example Fred has a wife, Nancy, who has no IRAs whatsoever, Nancy could make a $5,500 contribution to a nondeductible IRA and convert the entire $5,500 without there being a taxable event whatsoever (excluding any growth that might have taken place in the account from the time Nancy puts money into the IRA until when she converts it).
Ways to Avoid or Reduce Aggregation Rule
There are a few strategies that can be used to reduce or completely eliminate the impact of the aggregation rule. First, 401(k)s and other employer plans (sans SEP and SIMPLE plans, as previously stated) are omitted from the IRA aggregation calculation. Some 401(k) plans allow for Traditional IRAs to be rolled into the plan, which, by doing so, would remove those assets from the calculation. Another way to mitigate the IRA aggregation rules would be to keep retirement assets inside a 401(k) instead of rolling them into an IRA when changing jobs, particularly if you see yourself wanting to take start making Backdoor Roth conversions in the near future. If you’re thinking about doing a backdoor Roth conversion, it’s worth your time to see what the tax ramifications will be for doing the transaction and analyze to see if there are any ways to reduce or eliminate the amount of assets in deductible IRAs.
Step Transaction Doctrine
The second major issue to keep in mind when considering whether to do a Backdoor Roth conversion is to pay attention to the IRS’ step transaction doctrine. Basically what this rule states is that a series of transactions that are done in quick succession need to have an actual purpose that can be justified on their own merit individually to be considered independent transactions or all transactions could be seen as one integrated tax event instead of several independent transactions. As it pertains to Backdoor Roth conversions, instead of an individual putting money into a non-deductible IRA for tax deferred growth (Step 1) and then converting it to a Roth IRA (Step 2), the tax court could interpret that the individual was trying to circumvent the MAGI rules and the true intent of the series of transactions is solely to make a contribution directly to a Roth. The key component here is time. The longer the period of time between nondeductible IRA contribution and conversion to a Roth IRA, the less likely that the IRS would invoke the step transaction doctrine.
So with that said, the magic question is how long of a period of time needs to separate the two transactions in order to not be in danger of step rules? The answer is it depends on who you talk to. This is a grey area that has varying opinions across the industry. Some, correctly, point out that, while technically, a backdoor Roth conversion could fall under step rules if done in quick succession, since the MAGI rules were changed in 2010 the IRS has not ruled against a single individual who has done a backdoor Roth conversion. Other industry experts, such as Ed Slott and Michael Kitces, still encourage people to wait a period of time before converting the nondeductible traditional IRA contribution to a Roth, with Slott’s company recommending waiting a month before conversion and Kitces recommending waiting a year before the conversion respectively.
My Own Personal Philosophy on Step Rules
In my own personal practice, I encourage my clients to wait at least a month before converting to a Roth IRA. While I agree that the IRS has never punished a taxpayer for doing an immediate conversion, I don’t think it is that much extra work to wait a month before converting and the additional income tax that might be incurred from growth in the account over the month should not be substantial. On the flip side, however, should the IRS ever decide that they are going to crackdown on Backdoor Roth Conversions, the month that separates the initial contribution from the conversion should keep us above reproach as it relates to step rules.
Conclusion
The backdoor Roth IRA could be a great way for those that are above the Roth IRA's MAGI limits to still contribute to a Roth IRA, just be aware of the rules surrounding the transaction. If you have large amounts in IRAs and do not have the ability to roll them into your employer's 401(k) plan at work, then this strategy may not be optimal. If you are wondering if this strategy is right for you, consult your financial planner and/or tax advisor for more individual guidance.
If you want to have a more detailed discussion on Backdoor Roth IRAs and if the strategy is the right fit for your particular situation, feel free to email me at daniel@sweetgrassfp.com or schedule a free introductory consultation.
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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Daniel Patterson, and all rights are reserved. Read the full disclaimer here.
