Poking the bear is a venture best reserved for hibernation. Fortunately for taxpayers, winter has arrived for a popular retirement savings strategy. A “back door” contribution to a Roth IRA sidesteps limitations that prohibit taxpayers from making them. Because the strategy is accomplished through a series of steps, many have questioned its viability, as it seemingly diffuses the intent of the limitations. Those reticent about making backdoor Roth IRA contributions for fear of drawing IRS scrutiny may want to reconsider participating in the strategy. Recent statements from an IRS official and Congressional commentary indicate this strategy will not garner attention from the IRS.
The Backdoor Roth IRA
Individuals have two options for retirement savings through IRA contributions. Contributions up to $5,500 annually ($6,500 for taxpayers who are age 50 or older) can be made to a traditional IRA or Roth IRA and account balances will grow tax-free. Traditional IRA contributions are tax deductible, where future distributions are taxable at ordinary tax rates. Roth IRA contributions are not tax deductible, however future distributions are not taxable.
Taxpayers are not always eligible to make tax deductible IRA contributions. Thresholds come into play. Taxpayers begin to lose the ability to make deductible contributions to a traditional IRA when their 2018 adjusted taxable income (AGI) exceeds $63,000 ($101,000 for married couples with a covered spouse or $189,000 for married couples with a non-covered spouse). Taxpayers exceeding this AGI amount may still make nondeductible contributions to traditional IRA accounts. Because there is a higher threshold, Roth IRA contributions are highly desirable for many taxpayers, but these too are subject to eligibility criteria. Taxpayers begin to lose the ability to make Roth IRA contributions when their 2018 AGI exceeds $120,000 ($189,000 for any married couple).
Certain taxpayers desiring Roth IRA treatment realized the law provides another path to the same destination. For tax years after 2009, taxpayers may convert (roll over) a traditional IRA account to a Roth IRA account regardless of AGI levels. The roll over amount is taxable in the year of conversion, where the taxable amount generally is the excess of the amount converted over the taxpayer’s investment (basis) in the account. A taxpayer has no basis with respect to deductible traditional IRA contributions, but importantly, a taxpayer obtains basis equal to the amount of nondeductible contributions to a traditional IRA. Immediately after a nondeductible contribution to a traditional IRA, there is no excess of the account value over the taxpayer’s investment basis (assuming this is the only traditional IRA account the taxpayer owns). This reveals the backdoor Roth IRA contribution strategy. Because there is neither an AGI limitation nor a holding period required before converting a traditional IRA to a Roth IRA, taxpayers can immediately convert. And while the conversion is taxable, the taxable amount of a prompt conversion is zero.
This strategy contains one important caveat. Taxpayers owning more than one traditional IRA account are not deemed to own separate accounts for tax purposes. Moreover, such taxpayers have a single amalgam of investment basis and total account value for all traditional IRA accounts. If a taxpayer with multiple IRA accounts attempts a conversion, the taxpayer may not isolate the investment basis and account value attributable to one account when calculating the taxable conversion amount. A ratable computation instead is required, which means a taxpayer with multiple accounts likely will not have a zero taxable amount upon conversion (often, the taxable amount will be nearly equal to the entire conversion). The backdoor Roth IRA is therefore suited to taxpayers who do not own any other traditional IRA accounts.
Viability of the Strategy
Although the law provides for the tax results under each step of the backdoor Roth IRA strategy, its viability seemed questionable as it appears to sidestep the intent of the AGI limitations. In fact, courts use a “step transaction doctrine” in many cases to require that a series of formally separate steps be collapsed into a single step to achieve the substance of the overall transaction. Nevertheless, the Sixth Circuit in Summa Holdings v. Commissioner recently confirmed the principles of the backdoor Roth IRA strategy in its 2017 decision. Summa Holdings’s opening foray into the strategy’s efficacy was then bolstered by comments in the legislative history to the new tax law referred to as the Tax Cuts and Jobs Act (TCJA). Those comments essentially confirm the strategy, stating: “Although an individual with [AGI] exceeding certain limits is not permitted to make a contribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA.” Getting warmer.
And then there were the comments made by an IRS official on July 10 concerning the matter. Donald Kieffer Jr., tax law specialist for the IRS Tax-Exempt and Government Entities Division, also pointed to the TCJA legislative history. He then noted, “I don’t think you’ll find any specific legal or IRS guidance that says that,” but in this case, “. . . it’s allowed under the law.”
Roth IRA contributions are a popular retirement savings vehicle, and many taxpayers facing AGI limitations have cautiously implemented the backdoor Roth IRA strategy since 2010. In light of the recent court ruling, legislative comments, and informal IRS comments, the strategy appears viable. For more information on retirement savings vehicles and the backdoor Roth IRA strategy, please contact your CBIZ tax professional.
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