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IRS Blesses Backdoor Roth IRA Contributions

The long-running debate on whether a backdoor Roth is legal is over. While the Backdoor Roth IRA strategy has been employed by high-income individuals since 2010, its legality was questioned by some because of the IRS step doctrine. With the 2017 Tax Cuts and Jobs Act, however, the backdoor Roth IRA is now considered legal by Congress. Further, the IRS has now officially stated that they are “ok” with the back-door Roth strategy. In a Tax Talk Today webcast, Donald Kieffer Jr., tax law specialist (employee plans rulings and agreements), IRS Tax-Exempt and Government Entities Division, said the back-door Roth is allowed under the law.

Back door Roth IRA contributions are used by individuals whose income exceeds the limits for regular Roth IRA contributions (more on the rules below). Back door Roth contributions are done by making nondeductible contribution into an IRA and then converting that balance to a Roth. The taxable amount that is converted is added to your income taxes and your regular income rate is applied to your total income. However, if you left the contribution in cash, the gains realized upon conversion should be negligible or nonexistent.

Sounds easy enough, right? Well…it is if you have no other pre-tax IRA’s or rollovers. When you have other IRA’s it can be a bit more complicated and you need to be careful not to mistep. Why–because conversions to a Roth are subject to pro-rata rules. The pro-rata rule is an important, though commonly misunderstood rule that affects the taxation of IRA money. The pro-rata ule prevents people from only converting non-deductible IRAs (after tax) to Roth IRAs and thus avoiding the taxes that would normally be involved in the conversion process. This rule requires you to consider ALL of your IRAs as the same account. If you have a Traditional IRA, an IRA Rollover, SIMPLE IRA or SEP IRA, those balances are considered when it comes to determining your tax owed on the conversion.  For more info on pro-rata rules, check out this great article by Michael Kitces.

Quick refresher on Roth IRA’s:

A Roth IRA is a special retirement account that you fund with post-tax income (you can’t deduct your contributions on your income taxes). Once you have done this, all future withdrawals that follow Roth IRA regulations are tax free. Unlike with a traditional IRA, you don’t have to start taking annual required minimum distributions (RMDs) from Roth accounts after reaching age 70½. Instead, you can leave your Roth account(s) untouched for as long as you live if you wish. This important privilege makes your Roth IRA a great asset to leave to your heirs (to the extent you don’t need the Roth money to help finance your own retirement).

If you are single, you must have a modified adjusted gross income under $135,000 to contribute to a Roth IRA for the 2018 tax year, but contributions are reduced starting at $120,000. If you are married filing jointly, your MAGI must be less than $199,000, with reductions beginning at $189,000. To qualify for a Roth, you must have “earned income” (ie. money earned for work performed) in the year you want to make a contribution. Max contribution is $5,500, if over 50 you get an extra $1,000 you can contribute.

When does a Roth make sense?

If you expect to pay lower tax rates during retirement, you might be better off making deductible traditional IRA contributions (assuming your income permits), because the current deductions may be worth more to you than tax-free withdrawals later on. Annual Roth contributions make the most sense for those who believe they will pay the same or higher tax rates during retirement.

Distribution Rules:

Withdrawals from your Roth IRA will only be classified as qualified distributions if it has been at least five years since you first opened and contributed to your Roth IRA, regardless of your age when you opened it. An IRA owner can make penalty-free withdrawals at age 59½, for instance, but if he or she made the first contribution at age 56, the plan participant would need to wait until age 61 to withdraw any earnings made on that portion of the original contributions.  Some exceptions exist that allow Roth IRA plan participants to withdraw from Roth IRAs that otherwise would be subjected to taxes and the 10% early withdrawal penalty. For more info on this, refer to IRS publication 590.

This article is provided for general educational purposes only and should not be construed as individual advice. Please be sure to consult with your tax or financial advisor to see if a back door Roth contribution or Roth conversion strategy makes sense for you.