Executive Summary
Since the income limits on Roth conversions were removed in 2010, higher-income individuals who are not eligible to make a Roth IRA contribution have been able to make an indirect “backdoor Roth contribution” instead, by simply contributing to a non-deductible IRA (which can always be done regardless of income) and converting it shortly thereafter.
However, in practice the IRA aggregation rule often limits the effectiveness of the strategy, because the presence of other pre-tax IRAs and the application of the “pro-rata” rule limits the ability to convert just a new non-deductible IRA. On the other hand, those with a 401(k) plan that allows funds to be rolled in to the plan can avoid the aggregation rule by siphoning off their pre-tax funds into a 401(k) plan, and then converting the now-just-after-tax IRA remainder.
Perhaps the greatest caveat to the backdoor Roth contribution strategy, though, is the so-called “step transaction doctrine”, which allows the Tax Court to recognize that even if the individual contribution-and-conversion steps are legal, doing them all together in an integrated transaction is still an impermissible Roth contribution for high-income individuals to which the 6% excess contribution penalty tax may apply. Fortunately, though, the step transaction doctrine can be navigated, by allowing time to pass between the contribution and subsequent conversion (although there is some debate about just how much time must pass!). But perhaps the easiest way to avoid the step transaction doctrine is also the simplest – if the goal is to demonstrate to the IRS and the Tax Court that there was not a deliberate intent to avoid the Roth IRA contribution limits, stop calling it a backdoor Roth contribution in the first place!
Mechanics Of Making A Backdoor Roth IRA Contribution Via Conversion Of A Non-Deductible IRA
The basic concept of the “Backdoor Roth IRA Contribution” is relatively straightforward. Contributing directly to a Roth IRA is restricted for higher-income individuals; once a married couple has an AGI in excess of $193,000 (or $131,000 for an individual), the maximum contribution limit to a Roth IRA is reduced to zero. However, anyone with earned income can contribute to an IRA, regardless of how high their income is; at worst, higher income levels may limit the deductibility of that IRA contribution (for those who are an active participant in an employer retirement plan), but not the ability to make the IRA contribution.
In addition, under the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), there have been no income limits on Roth conversions of traditional IRAs since 2010. As a result, anyone who has funds in a traditional IRA – whether originally deductible or not – is eligible to do a Roth conversion. In other words, while income limits remain on Roth contributions, there are no income limits for a Roth conversion.
Thus, by putting the two together, those with higher income who are not able to make a Roth IRA contribution are able to effectively work around the income thresholds by making a non-deductible IRA contribution (permissible even at high income levels) and then converting it to a Roth (again permissible even at high income levels). (Note: In order to do an IRA contribution at all, it is still necessary to have qualifying earned income in the first place.)
If the IRA contribution is deductible, the end result will be a contribution to an IRA that produces a tax deduction, followed by a Roth conversion that causes the income in the IRA to be recognized for tax purposes. In the end, this means there will be an IRA deduction of up to $5,500 in 2015 (reported on Line 32 of Form 1040), Roth conversion income of up to $5,500 to match it (reported on Line 15 of Form 1040), and since both are above-the-line income/deductions on the tax return, the net result is $0 of Adjusted Gross Income (AGI) and a $0 tax liability, even while getting the whole $5,500 in a Roth IRA!
In the case that the IRA contribution is not deductible (e.g., because the high-income earner is an active participant in an employer retirement plan, and his/her income level has therefore made the contribution non-deductible), the net result is still the same. The contribution into the IRA itself produces no tax deduction (Line 32 of Form 1040 is $0), and the after-tax portion of the contribution is reported on Form 8606. The conversion of that non-deductible IRA is a taxable event, but the portion of the IRA that is attributable to non-deductible contributions is treated as a return of principal and thus has no tax consequences (thus Line 15a of Form 1040 is $5,500 but 15b reporting the taxable amount is $0). In the end, this means there will be no deduction for the IRA contribution, and no income from the Roth conversion of that after-tax money, and the net result again is a zero impact on AGI and a tax liability of $0, while still getting the whole $5,500 into a Roth IRA!
Ultimately then, as the above graphic shows, either way the net result is that $5,500 goes into an IRA, $5,500 ends out in a Roth IRA, and the net impact on Adjusted Gross Income (AGI) is $0, which means the tax impact is $0! The IRA contribution is always permitted (as long as there's earned income), and at that point it doesn't actually matter whether it's a deductible contribution or not, because the net result after Roth conversion is always the same - $0 of AGI, and $0 of tax liability!
Notably, though, while this strategy of making a Roth IRA contribution through the "back door" by making a (potentially non-deductible) traditional IRA contribution followed by a Roth conversion seems relatively straightforward, there are some important caveats to consider in executing the strategy.
The IRA Aggregation Rule Under IRC Section 408(d)(2)
The first caveat to the backdoor Roth contribution strategy is what’s called the “IRA aggregation rule” under IRC Section 408(d)(2).
The IRA aggregate rule stipulates that when an individual has multiple IRAs, they will all be treated as one account when determining the tax consequences of any distributions (including a distribution out of the account for a Roth conversion).
This creates a significant challenge for those who wish to do the backdoor Roth strategy, but have other existing IRA accounts already in place (e.g., from prior years’ deductible IRA contributions, or rollovers from prior 401(k) and other employer retirement plans). Because the standard rule for IRA distributions (and Roth conversions) is that any after-tax contributions come out along with any pre-tax assets (whether from contributions or growth) on a pro-rata basis, when all the accounts are aggregated together, it becomes impossible to just convert the non-deductible IRA.
Example. Jeremy has $200,000 of existing IRA assets, accumulated from years of deductible IRA contributions plus growth when he was younger, along with a rollover from an old 401(k) plan. Jeremy is now a high-income earner, and wishes to make a $5,500 contribution to a non-deductible IRA, with the plan to convert that $5,500 into a Roth IRA.
However, due to the IRA aggregation rule, Jeremy cannot just convert the $5,500 non-deductible IRA contribution, even if it is help in a separate/standalone account. Instead, Jeremy must treat any $5,500 conversion from any account as a partial conversion of all of his IRA assets.
Accordingly, if Jeremy tries to do a $5,500 Roth conversion (from combined IRA funds that now total $200,000 plus new $5,500 contribution equals $205,500), the return-of-after-tax portion will be only $5,500 / $205,500 = 2.68%. Which means the net result of his $5,500 Roth conversion will be $147 of after-tax funds that are converted, $5,353 of the conversion will be taxable, and he will end out with a $5,500 Roth IRA and $200,000 of pre-tax IRAs that still have $5,353 of associated after-tax contributions (the remaining portion of the $5,500 non-deductible contributions that were not converted).
Notably, the net effect of the IRA aggregation rule is that only a portion of the non-deductible contributions can actually be converted, even if the non-deductible contribution is made to a new account and converted separately because the IRA aggregation rule combines all the accounts for tax purposes anyway! In fact, the IRA aggregation rule effectively “transfers” a large portion of the after-tax funds from being associated with the new $5,500 IRA over to the existing IRA instead!
Avoiding The IRA Aggregation Rule Via 401(k) And Other Employer Retirement Plans
While the IRA aggregation rule does combine together all IRA accounts to determine the tax purposes of a distribution or conversion, it’s important to note that the rule only aggregates together IRA accounts, and only the traditional IRA accounts for that individual.
Thus, a husband and wife’s IRA accounts are not aggregated together across the marital unit (although the husband still aggregates all the husband’s IRAs, and the wife aggregates all the wife’s IRAs). Nor are an individual’s own IRAs aggregated together with any inherited IRA accounts on his/her behalf. And any existing Roth IRAs – and the associated after-tax contributions that go into Roth accounts – are not aggregated either.
In addition, any employer retirement plans – e.g., from a 401(k), profit-sharing plan, etc. – are not including in the aggregation rule. However, a SIMPLE IRA or SEP IRA, both of which are still fundamentally just an “IRA”, are included.
The fact that employer retirement plans are separated out from the IRA aggregation rule means first and foremost that as long as assets stay within a 401(k) or other employer plan, they can avoid confounding the backdoor Roth strategy. Thus, in the earlier example, if Jeremy’s $200,000 IRA was a $200,000 401(k) instead, then the $5,500 non-deductible contribution to an IRA really could be converted on its own, because that would be the only IRA involved.
The second opportunity that emerges when employer retirement plans are not included in the IRA aggregation rule is that funds in an IRA can be removed from the aggregation rule by rolling them into a 401(k) or other employer plan. Thus, again continuing the earlier example, if Jeremy wanted to begin doing backdoor Roth IRA contributions, he could roll over his $200,000 IRA into a 401(k) plan, reducing his IRA accounts to zero, and then open a new IRA with a new non-deductible contribution and just convert that account.
In fact, under IRC Section 408(d)(3)(A)(ii), when funds that are rolled from an IRA specifically to an employer retirement plan, the transfer may not include any after-tax assets at all. In other words, if (under the IRA aggregation rule) Jeremy has $205,500 of total IRA assets, including $5,500 of after-tax funds, he cannot roll all $205,500 into a 401(k) plan even if he wanted to. Instead, he can only roll the $200,000 of assets that would be taxable if distributed.
In essence, this rule becomes an exception to the normal “pro-rata” rule that applies to IRA distributions and rollovers, and permits IRAs with a combination of taxable and after-tax funds to “siphon off” the pre-tax portion by rolling into a 401(k), leaving only the after-tax funds as a remainder to then be converted (and/or to receive subsequent non-deductible contributions to convert in future years!).
Of course, the most important caveat to this rule is simply that the individual must have a 401(k) plan that accepts roll-in contributions in the first place, which is not always the case. In the extreme, if the individual has any Schedule C income for consulting or other self-employment activity (and no other employees), he/she could even create an individual 401(k) and make a small contribution from income, establishing the account which can subsequently be used to accept roll-ins from his/her other IRAs to execute the strategy.
Backdoor Roth IRA Conversions And The Step Transaction Doctrine
The second potential blocking point for doing a backdoor Roth contribution is called the “step transaction doctrine”, which originated decades ago in the 1935 case of Gregory v. Helvering, and stipulates that the Tax Court can look at what are formally separate steps of a transaction that have no substantial business purpose to be separate, conclude that they are a really just a single integrated tax event, and treat it as such.
In the context of the backdoor Roth contribution, this means if the separate steps of non-deductible IRA contribution and subsequent conversion are done in rapid succession, there is a risk that if caught the IRS and Tax Court may suggest that the intent was to make an impermissible Roth contribution… and then disallow it (and potentially apply an excess contribution penalty tax of 6%), if the individual’s income was too high to qualify in the first place.
Example. Betsy earns over $250,000 per year, and wishes to make a Roth IRA contribution in 2015, but cannot because her income is too high. Instead, Betsy decides to pursue the “backdoor Roth contribution” strategy, and makes a non-deductible IRA contribution on July 1st, followed up with a conversion to a Roth IRA on July 2nd (as soon as the funds have officially been deposited in the IRA account and are available to transfer to the Roth IRA account).
The fact that Betsy did the steps in rapid succession implies that her intent all along was to complete a Roth IRA contribution that she was not allowed to make due to her income. According, under the Intent Test of the step transaction doctrine, if the IRS challenged the situation, the Tax Court may conclude that Betsy really did just make an impermissible Roth IRA contribution, which would then require her to remove the funds from the account, and be subject to a 6% excess contributions penalty tax as well.
It’s crucial to recognize that with the step transaction doctrine, each step of the transaction continues to be entirely legitimate. The point is not that each step cannot be legally done, nor even necessarily to say that they can’t be done one after the other. The ultimate point of the step transaction is that when the multiple steps are done with the clear intent of accomplishing a single transaction, though, the Tax Court can recognize (and tax or penalize) it accordingly.
Accumulating The 6% Excess Contribution Penalty Tax On Multiple Roth IRA Contributions
Notably, because the excess contribution penalty tax applies every year the contribution is not corrected, there may even be risk that a backdoor Roth contribution made in the distant past (beyond the statute of limitations) could still create issues, because while the original backdoor Roth contribution may no longer be challenged for that tax year, the subsequent years that the impermissible contribution remains in the account would still be within the statute of limitations. And arguably, if the excess contribution penalty was never reported on IRS Form 5329 in the first place, the statute of limitations may never even start on those prior years.
Thus, for instance, if someone had done backdoor Roth IRA contributions that ran afoul of the step transaction doctrine for 5 years in a row, the earliest contributions from 4 and 5 years ago might no longer be subject to penalties for those years (or might if the IRS deems failure to file Form 5329 prevented the statute of limitations from starting), but either way in the current year the taxpayer could still face penalties for each of the 5 improper contributions that still remained in the account re-creating new excess contribution penalties every year (although the most recent might still be corrected)! And if enough such penalties compound, it's even conceivably possible to trigger a 20% accuracy-related penalty as well!
Avoiding The Step Transaction Doctrine On Your Roth IRA Backdoor Contribution
So how is the step transaction doctrine avoided? In this context, the step transaction doctrine applies to a series of steps done in quick succession that have the substance of a single whole (and not permitted) transaction, such that the court determines by looking at the end result that it was the taxpayer's intent to do the single-step transaction in the first place.
Accordingly, then, the key to avoiding the intent test of the step transaction doctrine is conceptually simple: put more time and space between the steps, to clearly establish that they were separate and independent decisions, and not part of a single whole. If there is a deliberate time gap between when the non-deductible IRA contribution is made, and when the subsequent Roth conversion occurs, it's easier to claim that the end result of dollars in the Roth wasn't part of a sole intent to circumvent the rules. Again, the reality is that each event separately is permissible, but the goal is to clearly establish that each step really is separate.
The caveat is that there's no hard-and-fast rule about “how long” it takes to avoid the step transaction. A prudent rule of thumb in the context of the backdoor Roth contribution is to wait a year (though notably, Jeff Levine and the team at Ed Slott and Company believe a much shorter time period is sufficient, such as waiting "one statement" until an end-of-month statement is released to show the IRA contribution being made). For instance, in a similar step-transaction-doctrine issue with partial 1035 annuity exchanges and subsequent liquidations (which allowed annuity owners to get more favorable treatment in the multi-step process than could have been obtained if treated as a whole), the IRS ultimately declared in Revenue Procedure 2008-24 that as long as the taxpayer waited at least 12 months between the 1035 exchange and the subsequent liquidation, it would be allowed. Thus, for example, if the current non-deductible contribution is made in June of 2015, the Roth conversion would be done sometime next June (after a full 12 months has passed).
For those who plan to do ongoing annual Roth IRA backdoor contributions, the strategy might be repeated again from year to year, where each non-deductible contribution is made, after 12 months that amount is converted (and the account balance goes to $0), and then a few days or weeks later a new non-deductible IRA contribution is made again, which in turn will be converted again another 12 months hence. This allows for a clear sequencing of cash flows, where each non-deductible contribution can clearly be shown to have had time to “age”, introducing the possibility that circumstances might have changed, and affirming that the subsequent conversion was an independent transaction.
And ideally, the funds should actually be invested during this intervening year as well. While investing the funds creates the potential that there will be a small tax liability when the conversion occurs if there was any growth along the way (if the $5,500 account grows to $5,750, the $250 of gains will be taxable at the time of Roth conversion). However, a tax liability will only occur if there was growth (which still isn’t a bad thing in the end!). And in reality, the fact that the funds were invested for growth, and had the possibility of creating a tax liability, is also what helps to reinforce that the steps were independent and not done with the sole intent of defeating the Roth IRA contribution limits as a step transaction!
But perhaps the most important to step avoid the step transaction doctrine is the simplest one: do not, in any notes or records, indicate that you are doing to do a “backdoor Roth IRA contribution” in the first place! After all, the reality is that the application of the step transaction doctrine is based on the court’s determination of intent – so when you say you are trying to do a backdoor Roth IRA to bypass the Roth contribution income limits, you are making the case for the IRS!
In addition, it’s important to note that in the case of financial advisors, client notes and records are discoverable documents if the client winds up in Tax Court! Unlike in the case of CPAs in certain circumstances, non-CPA client notes and advisor-client communication are not privileged (confidential even from the courts). Thus, advisors should also be cautious not to record in the advisor’s CRM and client file that the advisor is facilitating a backdoor Roth contribution, or risk that the advisor’s recommendation to do a “backdoor Roth contribution” is the very document used against the client to defeat the strategy!
Risk Of Getting Caught Vs Risk Of Being Penalized Under The Step Transaction Doctrine
It’s important to recognize that the step transaction doctrine is ultimately not a black-and-white test; instead, it is a nuanced interpretation of the facts and circumstances of the situation. In point of fact, this is why it has evolved as a judicial doctrine in the courts, not merely as an arbitrary rule that the IRS can apply at will.
In addition, the reality is that current reporting systems for IRA contributions and conversions generally do not track (in the automated reporting to the IRS on Form 1099-R and Form 5498) the exact days on which a non-deductible IRA contribution and Roth conversion occurred, nor from which accounts (and whether it was related to the same account). Which means the IRS has no real way to detect potentially abusive backdoor Roth contributions, short of discovering them by some other means (e.g., a random audit) and then raising the issue.
As a result, it is fair to acknowledge that the actual risk of getting “caught” with a questionable backdoor Roth contribution is low. Nonetheless, though, for someone who is caught, it may be difficult to defend that a backdoor Roth contribution was not a step transaction, if they were in fact done in very rapid succession. This is roughly analogous to speeding by driving 57mph in a 55mph zone; the odds that a police officer pulls you over are low, but if you are pulled over and end out in traffic court, you can’t really dispute that you were guilty of speeding (and at best, you can just ask for leniency on the punishment!).
On the other hand, given the dollar amounts involved, if the client is challenged, it’s almost certain in practice the client will just choose to acquiesce and pay any penalties the IRS assesses, as the cost to fight the matter with the IRS will likely be worse than just accepting the consequences and moving on. Though given that repeated years’ worth of backdoor Roth contributions could create a compounding excess contribution penalty tax (potentially even compounding enough to trigger a 20% accuracy-related penalty in the final year as well), eventually it may be the case that a client will wish to fight to defend the strategy.
However, from the IRS’ perspective, as the magnitude of dollars engaged in the strategy increases, that may also increase the likelihood that the IRS will pursue the matter in the first place. And in fact the reality that the dollar amounts involved are typically still small may indicate why the IRS has not aggressively pursued the strategy… at least, not yet?
Guide To How To Do A “Backdoor Roth IRA Contribution” Without Getting In Trouble
So in the end, what is a "backdoor Roth contribution"? A backdoor Roth IRA contribution is simply making a (typically non-deductible) IRA contribution, followed by a subsequent Roth conversion, even if you're otherwise over the income limits to make a normal Roth IRA contribution, all without running afoul of the step transaction doctrine.
Given all these dynamics, how should a “Roth IRA backdoor contribution” be accomplished? By following these steps:
How To Do A Backdoor Roth IRA Contribution Safely
- Verify there are no other pre-tax IRAs
- If there are, roll over existing pre-tax IRAs to a 401(k) (if available) to avoid the IRA aggregation rule
- Contribute to non-deductible IRA (if eligible)
- Invest funds in the non-deductible IRA
- Keep invested for 1 year (or if you're more aggressive follow the "one-statement" rule)
- Convert to Roth IRA
- Repeat steps 2-5 annually as desired
- Do not at any point along the way note that you are doing a “backdoor Roth contribution”!
It’s also worth noting that with the IRS’ decision in IRS Notice 2014-54 to allow after-tax funds in 401(k) plans to be split upon distribution (which allows after-tax funds to be converted to a Roth), a similar “deferred Roth contribution” is now possible with employer retirement plans that allow after-tax contributions as well. In the extreme, this can even be a form of “supercharged backdoor Roth” if the plan allows in-service distributions to repeat an annual contribute-then-convert process. Though again, particularly in the context of an annually repeated strategy, clients should be cautious not to trigger the step transaction doctrine.
Ultimately, it remains to be seen how long the backdoor Roth contribution will continue to be allowed. President Obama’s budget recommendations earlier this year did include, in the so-called Treasury Greenbook, a proposal that would outright prevent any after-tax funds in a retirement account to be converted to a Roth at all, which would “kill” most forms of the backdoor Roth strategies (though notably, it would still be possible if the IRA owner was not a participant in an employer retirement plan and was still making a pre-tax IRA contribution to convert).
For the time being, though, the “backdoor Roth IRA contribution” strategy does remain available… at least, as long as you don’t make it clear that’s what you’re trying to do!!
So what do you think? Are you recommending a 2015 "backdoor Roth IRA contribution” to clients to implement? Have you ever had a client who faced a challenge to the strategy? Do you plan to wait (between contribution and subsequent conversion) when executing the backdoor Roth IRA conversion strategy in the future?
Michael – Great summary. I seem to recall reading that filing a form 5329 each year showing zero penalty could help to bring closure here. Of course, it could also be taken as a “kick me” audit invitation. Any thoughts on that?
Form 5329? Do you mean the 8606 perhaps?
Meg,
No. I am still on extension myself and waiting for my accountant, so I haven’t done it myself yet, but I saw an article from Natalie Choate and if I understood it correctly form 5329 is the one you file to pay penalties. As I understand it, if you don’t file it the statute of limitations never runs but if you do file it showing zero penalty that starts the statute running. That should help to limit the damage.
So, you want to file a blank Form 5329 so that the statue of limitations kicks in?
Sorry for the delay, but I was out of town. Not a blank form 5329, but one showing $0 for the taxable amount and for the tax due.
Michael, after seeing for years tax shelters proposed as legitimate transactions by reputable companies (such as the ones KPMG was penalized strongly for), isn’t there still a risk when there is a pattern for roth conversions? While I know it is being proposed everywhere, for those not able to qualify for a ROTH contribution that are using the back door strategy, it seems like the strategy is only worth their time and effort if it is done year after year vs 1 or 2 times. I just wonder about putting my stamp of approval on something that does not seem to be proven in tax court. Again I am thinking of previous tax strategies that were blessed by reputable CPA firms but later were challenged by the IRS.
I guess to further answer your question. At this time, I am not recommending Roth IRA conversion unless their CPA has already given the blessing. I still warn them that it is going against the “spirit” of the ROTH contribution limits and that will be a concern until I see a clear “blessing of the strategy”. Maybe I am being too conservative on this issue but I am not comfortable with the strategy yet.
Stephen,
Strictly speaking, a steady pattern of systematically doing the transaction this way probably still has some implication of intent for the step transaction.
But the key is that by allowing a full year to pass, there’s time that the situation/circumstances could change, and that you MIGHT NOT actually end out doing it after the year passes. And that’s the whole key to making the case that these are separate and independent steps – that although they happened to be done, sequentially and repeatedly, there was enough time and opportunity for the situation to change and for them to NOT be done.
By contrast, when someone adds the money now, lets it sit in cash for days or weeks, and then converts shortly thereafter, there wasn’t even time FOR the situation to have changed to let the transactions be independent in the first place.
But alas, as noted in the article, there is no hard and fast rule here. The step transaction doctrine is a facts-and-circumstances evaluation by the court. At best, you can simply set the most defensible position you reasonably can.
– Michael
Thanks MIchael. I appreciate your very thorough article and analysis.
Michael, I am a new subscriber to your newsletter. A question regarding the ‘Back Door Roth’, assuming you have no pre-tax IRAs. Suppose you made a 2016 $6,500 ‘catch-up’ non-deductible contribution just prior to year end on 12/31/16. And then you made a 2017 $6,500 contribution on 1/2/2017. Using the Levine/Slott aggressive time counting approach, could you convert your IRA’s combined total $13,000 after a month or so? (Assuming of course that the IRS continues to tacitly permit this strategy into 2017.) Thank you for your response. –Shawn
Great article! Thanks for this refresher, and for the new tips!
Michael,
What are your thoughts on the ordering rules for withdrawals of basis after a conversion has been made. Assume you successfully complete a non-deductible conversion and you have no earnings(say the market was literally flat) in the account. You then have an emergency 3 months later and need access to cash, in this strange unlikely scenario assume its the Roth IRA. The ordering rules are as follows:
1.Regular participant contributions
2. A Roth conversion
or rollover of taxable assets (Traditional IRA assets for which a tax
deduction was allowed and pretax amounts from employer plans such as
qualified plans, 403(b) and governmental 457(b) plans. These assets are
taxed when converted or rolled over to the Roth IRA).
3.A Roth conversion or rollover of nontaxable assets (Traditional
IRA assets for which there was no tax deduction and after-tax assets
from employer plans such as qualified plans and 403(b) plans). These
assets are not subjected to income tax when distributed or converted to a
Roth IRA.)
4.Earnings on all Roth IRA assets
How is this withdrawal treated? My thought was the earnings would be subject to the 10% penalty but not the basis, but I can’t find anything that confirms or denies what I believe. Based off of your article I’m also assuming if the IRA was deductible the full 5500 would be subject to the 10% penalty, and that person would need to wait the full 5 years to access the basis? As always your articles are the best.
Does anyone from the audience know the answer?
First, there really isn’t a full 5 year wait. The conversion is back dated to the start of the tax year. Dec 31st conversion would have a Jan 1 start date. And I think you could take it anytime in the 5th year. So I think it can be as short as 3 calendar years and a couple days.
To answer your question, it depends on your age. Is the individual beyond 59 1/2? If yes, conversion amounts could be withdrawn immediately but not earnings. Otherwise you will take the 10% hit.
Of course, I am just pulling this from a prior article.
https://qa.kitces.com/blog/understanding-the-two-5-year-rules-for-roth-ira-contributions-and-conversions/
And if it is an short-term emergency, there is nothing to say you can’t do a 60-day rollover. And then do an additional one from a spouse’s IRA to extend the loan period by an additional 60 days.
FYI, Roth 401(k) and Roth 403(b) plans rules are a little whacky. The holding period is determined by the date of the account that they are rolled into.
Kyle,
I understand the 5 year wait, and was using it as a simple
figure, and of course we are talking about someone under 59 1/2. If you
do a conversion with no earnings, you would only pay the penalty on the
earnings, so my questions is simply if their are no earnings, would you
in fact pay the penalty. That is the crux of the question. I appreciate your input but I’m asking a different question than the one you are answering.
Regards,
Ken
Understood, that was the question I was answering. 10% penalty. No different than the early withdrawl penalty from an Traditional IRA.
Kyle,
Again, I’m saying you isolate a non deductible IRA with no earnings. The 10 percent penalty is on the on TAXABLE amount. See early withdrawal penalty for non deductible IRA’s:
The early withdrawal penalty applies only to the taxable portion of your
early withdrawal. Since nondeductible contributions didn’t get you a
deduction when you made the contribution, you don’t have to pay the
early withdrawal penalty on that portion of the withdrawal. If your
entire withdrawal consists of only nondeductible contributions, you
won’t owe any early withdrawal penalties. Now couple that with that ordering rules for the conversion and you will see what you linked IS NOT the same thing.
For example: You do a 5,000 contribution into a non-interest bearing account non deductible IRA, and it has a basis of 5,000. The next day you pull out 5,000 for emergency. You wouldn’t pay any early distribution on that because its all basis. Now if you follow that logic forward and do a non-deductible contribution into a non-interest bearing account, and then convert that to a ROTH IRA, none of that would be taxable, and then if you made sure you had no assets in the second set of ordering rules, its then that I’m curious if you have penalty. I don’t believe their would be, because their wouldn’t be if you did from the original non-deductible IRA. So, again, I appreciate the link, and I understand the rules, but we aren’t talking about the same thing. If it were from a tradtional IRA with earnings then your link would be correct, but that isn’t what I’m talking about.
Regards,
Ken
Apologies for the misunderstanding. Honestly though, will this strange unlikely situation ever occur? This person only has $5,500 in an IRA account, yet they are unable to make deductible IRA contributions? Correct me if I am wrong, but you are then proposing that they convert it to a brand new account with a $0 balance?
Kyle,
What if they are a MD, maxing out their contributions to a 401k plan, and have been with one company their whole life. Or if I had them roll over their IRA assets back into a 401k so that the strategy was available to them.The account value and income limits don’t always move in conjunction so its entirely possible they have zero dollars in an IRA and 4 million in a 401k which would allow this to work.
Ken
Please read thru the Fairmark article. It discusses the early withdrawal of converted amounts.
http://fairmark.com/retirement/roth-accounts/roth-distributions/distributions-after-a-roth-ira-conversion/
Great article, very thorough. Aggregation rules generally get in the way for my clients. If not, I will continue to recommend.
GREAT article as usual, Michael! Larry Starr and I wrote an article in 2009 advocating this same strategy but it didn’t get the kind of attention that your stuff always does.
Thanks, Michael, as always, for this in-depth and detailed analysis and blueprint. One thing not mentioned by your commenters so far, re step #2: if the investment options in the 401(k) are lousy (high-cost, actively managed funds) compared to what are available in the IRAs, and/or the 401(k) plan itself has high fees, moving assets from the existing IRAs to the 401(k) could be a case of the tax tail wagging the investment dog, with the tax savings dwarfed by poor performance and costs. And if, to avoid that, funds are rolled back out of the 401(k) into the IRAs, that could be evidence of the intent to circumvent the rules, which is what all these machinations are designed to avoid in the first place!
How long does one need to leave the traditional IRA rolled in to the 401K before putting it back to the standalone IRA?
The term “Backdoor Roth IRA contribution” in and of itself sounds like you’re trying to get away with something. I prefer to use the term “Two-step Roth IRA contribution”.
What’s the latest on this? I can’t tell from the press reports I’m reading whether “backdoor Roth contributions” are alive or dead … and I have a client asking about it.
Johann,
There’s been no change from what’s written here. The Tax Extenders legislation had nothing on backdoor Roth – see https://qa.kitces.com/blog/congress-will-pass-2015-tax-extenders-path-legislation-permanently-reinstating-qcds-and-other-popular-provisions-and-without-any-change-to-dol-fiduciary-rules/
– Michael
Thanks, Michael. Just what my client was hoping to hear. It does seem like something they’re going to close eventually, though, no?
For someone pursuing the strategy you outline, would each annual Roth IRA conversion need to be a separate account? I.e., would someone doing this for 20 years necessarily have 20 separate Roth IRA accounts at the end?
this is the kind of BS that turns republicans into democrats. the backdoor roth is a clear violation of the spirit of the law and congress knows about it and the tax courts know about it and yet it goes on. it depresses me whenever i read about such abuses.
Any dollar kept away from the greedy hands of the government is a good thing not a bad thing.
Wrong. What turns republicans into democrats is stupidity
For deductible contributions the net result is not $0 tax liability since the income is only excluded in the first contribution and included in the latter. This results in a tax liability on $5500 of income. A Roth conversion is always a taxable event if the original balance was deducted for tax purposes.
1. My 401k allows non-deductible contributions and the ability to roll it over into a Roth 401k ever 6 months. Why is that okay and this IRA version questionable?
2. Why do non-deductible IRA contributions even exist other than to convert to a Roth? If my income is too high to make Roth IRA contributions and too high to make deductible IRA contributions then chances are I’m in at least the 25% marginal tax bracket. Why would I invest in a non-deductible IRA and be taxed at 25% when I could keep my money in a taxable account and be taxed at the 20% capital gains/dividends tax rate? Therefore, how can the IRS attack people for violating the spirit of the law when this back-door Roth IRA appears to be the entire purpose for the existence of non-deductible IRAs?
Michael, what happens on the *next* conversion.
1st time: I have 0 in any other IRAs its all in pre-tax 401k. I convert my $5,500 post-tax traditional IRA into a Roth IRA, so there’s no aggregation rule worries.
2nd time: I convert next years post-tax 5,500 from traditional IRA into the Roth IRA, which is
$5,500 and will become $11,000.
How does the aggregation rule apply ( or not apply ) now?
In the second year your IRA account balance is $0 because you converted all of it to a Roth in year 1. So year 2 will be identical to year 1.
Remember, the IRA aggregation rule aggregates PRE-TAX IRA accounts. Not Roth accounts. Once you convert dollars to a Roth, the Roth dollars are gone from the aggregation equation.
– Michael
Fantastic explanation, very clear and easy, just like the article. Thanks very much.
Michael – I like your suggestion of opening a solo 401k to roll IRA funds into. What if the taxpayer is already maxing out permissible 401(k) contributions via their W-2 job….can they open a solo 401(k) for their side consulting income and roll IRAs into the solo plan without making a deferral under the solo 401(k)? Or do they actually need to make a deferral to the solo 401(k) each year? If yes, I assume they could switch their W-2 deferral to 17k which would allow them to make a 1k deferral to the solo. Your thoughts are appreciated.
so wait….if I have qualified IRA accounts but my wife does not. Can she contribute to an IRA with after tax $ and roll over to a Roth without my (husband) IRA’s counting toward the IRA totals?
Correct, the IRA aggregation rule is only for IRAs in your own name (and tax ID number). You don’t have to aggregate your spouse’s IRAs, nor any inherited IRAs (that are still registered as an inherited IRA and not rolled over).
– Michael
Even if we file jointly on our tax returns?
Can you confirm the above is true, even if we file jointly?
Again, the IRA aggregation rule is only for IRAs in your own name and tax ID number.
Filing status is literally irrelevant for the aggregation rule. Your filing status will determine the taxes you pay ON your conversion income, but has zero relationship to the aggregation rule itself.
Your IRAs, your name, your tax ID. That’s what is aggregated.
– Michael
If your wife contributes to an IRA with after tax dollars, she could contribute directly to a Roth. Contributing to a traditional IRA and then converting to a Roth would be an unnecessary complicating step.
Hi Michael, Thanks for writing a great article. When doing a 2 step IRA conversion, do you need to open a new IRA account or can you use the empty IRA account from which you just rolled over the funds to a 401k? Can you rollover the IRA to a 401k and then make the contribution a few weeks later? Then I understand you are suggesting to leave the money in the IRA for one year prior to converting to a ROTH. I would love to hear your opinion. Thanks!
I have contributed to my Traditional IRA for almost 2 years. Is there any harm in converting all of the dollars at one time to the Roth?
Upon conversion, you’ll have to pay fed tax at your tax rate on the distribution.
May also have to pay state income tax, depending if you live in a state with income tax.
You’ll need to pay the taxes from some other money account or make up the difference to your converted Roth IRA contribution.
Michael,
To clarify, the aggregation rule includes SIMPLE and SEP IRA’s?
“While the IRA aggregation rule does combine together all IRA accounts to determine the tax purposes of a distribution or conversion, it’s important to note that the rule only aggregates together IRA accounts, and only the TRADITIONAL IRA accounts for that individual.
In addition, any employer retirement plans – e.g., from a 401(k), profit-sharing plan, etc. – are not including in the aggregation rule. However, a SIMPLE IRA or SEP IRA, both of which are still fundamentally just an “IRA”, are included.”
I’m trying make sense of the aggregate rule and how it impacts the timing of your example in the chart above for avoiding the step transaction doctrine. In that example I make a non-deductible contribution of $5,500 to a traditional IRA on 6/17/15. I then convert this $5,500 + or – market appreciation/depriciation into a Roth IRA on 6/19/16. So for the 2015 tax year, (balance as of 12/31/15) all of my IRA balances are considered to be in a traditional. Continuing on with your example, i make another non-deductible contribution of $5,500 to a traditional IRA on 6/26/16. I then convert this $5,500 + or – market appreciation/depreciation into a Roth IRA on 6/28/17. So for the 2016 tax year (balance as of 12/31/16) ~ half of my IRA balance are in a Roth and the other half of my IRA balance are in a traditional. Wouldn’t I be subject to the aggregation rule because of this? Is there a specific day each year that all of your IRA balances need to be in a Roth to not be subject to the aggregate rule?
I have inadvertently contributed 10K of nondeductible funds to an IRA. All of my other IRA funds were pretax contributions. I would like to roll the pretax contributions into a 401k. Is it necessary for me to know the percent of IRA funds that were not tax deductible or can I move everythingand just leave behind the 10K original basis. Premise is that I will pay taxes on any growth it may have generated when I withdraw in retirement. Or do I have to segregate the 10K and it’s fractional earnings based on total earnings of the IRA. Not sure if this question is clear. Thanks in advance for your help!
Please help:
In 2016, I had $18k in traditional rollover IRA, and $12k in Roth IRA, from the days that I could still make Roth IRA contributions. In January 2017, I rolled-over my $18k trad IRA to my employer-sponsored 401k.
I got married in July 2016 and my wife has no IRA accounts.
Since I had traditional IRA assets as of Dec 31, 2016, can I still make a non-deductible IRA contribution for 2016 and convert to Roth in 2017?
I presume that I can only start to make a backdoor Roth IRA contribution for 2017?
My wife makes minimal income. Can she make a direct Roth IRA contribution, or does she have to make a backdoor Roth IRA due to my income exceeding the Roth IRA contribution limit?
Is there such thing as a “joint IRA” account that I could open and make contributions for both me and my wife?
Thank you.
If you’re married filing jointly, the income limits apply to your combined income. So at $184,000 combined AGI, you can still EACH contribute $5500 to separate Roth accounts the normal way. No need for a conversion. It doesn’t matter what portion of that $184k each spouse earned, as long as you’re filing jointly.
The accounts must be separate though. There’s no such thing as a joint IRA between spouses, hence the I of IRA being “Individual.” I went through the exact same thing this year, so I read a ton of tax law.
It’s still unclear to me whether you can both contribute to a Roth the normal way AND do a conversion the same year, effectively contribute $11k each in one tax year. I think the answer is no, and that’s what I’m sticking with to be safe.
Wondering if you have thoughts on the following: Can an individual with no prior IRA account balances do a non-deductible IRA contribution followed by Roth conversion followed by a 401(k) rollover (to a Rollover IRA) in the same tax year? (and thus avoid the pro-rata rules on the Roth conversion?) I am hearing different stories from different folks. Some say it’s a timeline question, so “yes.” Others say since it’s in the same tax year (2017 in this case) then “no,” you’d have to assume the rollover was existing IRA assets already present (even though they were still in 401(k)s) at the time of the non-deductible contribution and conversion.
Interesting– I’ve read dozens of financial articles and none has mentioned that the IRS may challenge a Roth conversion (as you discuss here). My question is: what if someone contributes to a nondeductible IRA then converts it to a Roth and then (in the same tax year) contributes to a SEP or SIMPLE. The IRS tax reports have no way to know that the conversion was completed prior to the SEP or SIMPLE contributions. Wouldn’t they aggregate the nondeductible IRA plus the SEP/SIMPLE balances in calculating the tax liability due?
If one high-income earner goes to tax court and the court rules against Backdoor Roth Conversion, this would affect thousands, if not, millions of people who do the IRA to Roth IRA conversion. This would potentially increase the govt revenue, but there will likely be riots, funded and sponsored by not only the people but financial advisors, insurance agents, etc. who help their clients do the Backdoor Roth Conversion :).
The IRS has shut down far bigger tax loopholes over the years.
Limiting the backdoor Roth would NOT kill the IRA to Roth IRA conversion.
It would kill “backdoor” Roth contributions for the top 10% – 20% of households who were circumventing the contribution limits to the tune of $5,500/year (and of course not nearly all of those households ‘eligible’ were even doing it).
That’s not exactly torches-and-pitchforks kind of tax disruption. 🙂
– Michael
Nice article and more in-depth than some others I’ve found and read.
Interesting how you mentioned the ‘possible’ IRS/Tax Court challenges If the taxpayer(s) were ever audited as other articles on the backdoor Roth conversion didn’t mention it, afaik.
You forgot to mention about taxpayers that may Only have Non-Deductible IRAs. Hopefully they remembered to file Form 8606 for those related years listing the related contributions.
Theoretically, If those taxpayer then made a Backdoor Roth Conversion, then none of the contributions should be taxable, provided it was within the original total contribution amount so the distributions should be considered basis recovery.
Mike – Do you have any specific examples of cases where the IRS has applied the ‘step doctrine’ concept to non-deductible conversions. The article is very helpful, but I was unable to find any court documents specifically regarding non-deductible conversion scenarios. To clarify, maybe the article is alluding to the ability of the IRS to approach in this fashion … but it has not actually happened yet (with non-deductible cont. and conversion scenerios)? Thanks again for the hard work!
I’m not aware of any Court Case on this. From a practical perspective, I doubt there will be anytime soon. It’s easier for the taxpayer to just take the penalties and fix it than pay a lawyer hundreds of dollars per hour to fight it.
I have talked with more than one advisor who’s had clients that had their backdoor Roth conversions turned back by IRS agents during audit, though. They’re well aware that it’s an issue, and at least some know how to spot it…
– Michael
Any chance you would be able to acquire more information on what the IRS actually stated in those cases. Are they specifically citing the step doctrine in those audits? I haven’t been able to find one advisor or CPA in my area that has had one turned back. I am very interested in keeping clients on the IRS’s good side, but pretty much every high income investor i have come in contact with under 30 years of age is doing the steps immediately and thought I even saw a statistic from Vanguard that something like 30k people were doing immediate conversions on their platform. Since no ones opinion matters except the IRS or the tax court, would interested in any actual evidence from those sources which I haven’t been able to find.
Both were the same – the agent simply said it was “obviously” a Roth contribution, and wasn’t permitted. (Which is effectively invoking the step transaction doctrine. But no one talks about that in a routine audit. And as noted, it’s not worth taking it to Tax Court to fight it in most cases. If you get caught and challenged, you’ve already lost. Either the contribution, or the cost of an attorney or CPA to fight it.)
– Michael
I noticed that you said to invest funds in the non-deductible IRA for a year before conversion. Wouldn’t the gains then be taxable upon conversion?
Yes, gains will be taxable upon conversion. But you only pay taxes if you have gains. By definition you’ll still be ahead. And taxability for one years’ worth of gains in order to get decades and decades of subsequent tax-free growth is a fine trade-off.
By contrast, if you DON’T invest the money during the interim, you’ve waving a giant red flag for the IRS. Who invests their IRA in CASH for the long run? No one… except the person who is demonstrating their full intent to defraud the Roth contribution limits… :/
– Michael
Hi Michael, does this change now with the current tax law? I was reading an article from Forbes, and the article says the tax law approved the backdoor roth.
What is your take on the subject? If that is in fact true, does it not matter if you simultaneously contribute to a non-deductible IRA and then immediately convert to a Roth?
Michael, I don’t know whether you are still reading comments in this thread; I sure hope so, because your sharing of your knowledge is so generous and helpful. My question is: If I have left my non-deductible contributions sit in my IRA for a couple of years and they have now accrued non-substantial gains, may I rollover just the “gain portion” of the IRA’s existing funds to a solo 401(k) [assuming my plan will allow it], retaining the reported non-deductible “basis” amount in my IRA, so that I can then convert that entire remaining amount to my Roth IRA without having to pay taxes on the “gain” portion as I would be required to do if I just converted the entire amount to the Roth IRA. It seems like the IRS allows something similar when people “split” their rollovers from non-deductible 401(k) contributions, and the IRS will be taxing these gains when I eventually withdraw them from my solo 401(k), but I have not seen any direct answer to my question elsewhere.
Thanks.
Great article!! Very informative and exactly what I was looking for.
Mike, One question for you as I have a non deductible ira from 2015 which I plan to convert to a Roth now and only have to pay taxes on the $700 or so I have earned over the original $5500. I was also planning to contribute another $5500 for 2017 and maybe another $5500 now for 2018. Should I roll over the 2015 now keeping the stocks and then make my 17 and 18 contributions and roll those over later, or make them now and then roll all of it over in a month or so after my first statement? I prefer to get them into the Roth as soon as possible but with little risk. I appreciate any input.
Hi Michael, let’s say today (Jan 13, 2018), I roll over my existing $70K IRA into my employer’s 401K. I then make a $5,500 contribution to a nondeductible IRA for the 2017 year. In April, I make another $5,500 contribution to a nondeductible IRA for the 2018 year. Let’s say there’s no change in market value of my IRA (it’s currently $11,000). Am I subject to any aggregation rule taxes? Thanks
Apologizes for the late comment/question. Michael, when you describe the strategy about first funding a traditional IRA, taking the deduction, and then doing a Roth conversion (where the income is then recognized), are you saying this makes it a triple-tax free account? Meaning, the Roth IRA contribution doesn’t ultimately get taxed? If so, could you elaborate or direct me to the tax explanation for this, because I’m not understanding it fully. Many thanks, Carrie
If my wife is not working and she has a Roth IRA can I setup a traditional IRA and fund it, then transfer the $6000 through the backdoor Roth IRA even if I have a SEP IRA and Traditional IRA in my name only. I read that if you have a SEP and traditional IRA you can’t do a backdoor Roth but what about my wife? Thank you!
Hi Michael, thanks for this informative article. I am struggling to get some clarity on this since CPAs and attorneys are all telling me contradictory things – would love your advise:
CONTEXT: I have a 401K that I rolled over to IRA (Pre-Tax). Then, I made non-deductible contributions to it (Post Tax). Now, I am trying to ‘reverse’ my IRA back to 401K (Put all my Pre-Tax money back into 401K) and keep my Post Tax money in IRA and convert them to Roth so I can set up a backdoor roth.
Q1: I am being told that this ‘clean’ reverse separation isn’t possible and that aggregation rule will apply even though you state in your article that this is possible? Any thoughts on whether to proceed or do I face any risks doing this?
Q2: What is the process to do this. Vanguard told me they can do reverse characterization but I am curious how do I tell them what to reverse, what to keep and also how to calculate the ‘earning’s from my non-deductible contributions. I suppose when I ‘convert’ my traditional IRA to Roth, I’ll have to pay a one time tax on the ‘earnings’. Will Vanguard tell me that breakdown and what all tax forms will I need to fill out when i do this?
Any advise on both questions would be very much appreciated!
I’d be curious as to your take on Congress’ Conference Committee report notes on this, specifically in the footnotes 268, 269, 276 and 277 in here, which seems to bless it. Enjoyed your article above:
https://www.govinfo.gov/content/pkg/CRPT-115hrpt466/pdf/CRPT-115hrpt466.pdf
268 Although an individual with AGI exceeding certain limits is not permitted to make a con- tribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA, as discussed below.
269 Although an individual with AGI exceeding certain limits is not permitted to make a con- tribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA.
276 The provision does not preclude an individual from making a contribution to a traditional IRA and converting the traditional IRA to a Roth IRA. Rather, the provision would preclude the individual from later unwinding the conversion through a recharacterization.
277 In addition, an individual may still make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA, but the provision precludes the individual from later unwinding the conversion through a recharacterization.
Do I need to roll over my pension to my employer’s 401K to reap the benefits of the Roth conversion in the same year? I did the Roth conversion this year from my non-deductible IRA but I also need to find a “home” for my pension. It appears though if I roll over my pension to my non deductible IRA account, the pension amount would be part of the formula in that conversion if it is for the same year. What do you suggest I do? Thank you!