Bear Mountain Capital Inc.

Backdoor Roth IRA’s – Are They a Good Idea?

| February 17, 2015

Planning Perspectives | Portfolio Management

Many people are aware of the benefits of a Roth IRA: you put your after-tax money into it, after 20 or 30 years when you retire, you pull all of the money out tax-free.  This can be a big benefit when you consider the effect of compounding returns over time.

However, not everyone can contribute to a Roth IRA.  The reality is the IRS puts limitations on who can contribute based on income.  The more you make, the less you can contribute.  For example, if you are married and filing jointly and your adjusted gross income (AGI) is over $193,000 a year, you are not eligible to contribute to a Roth IRA.

This limitation has encouraged people to explore alternative strategies for funding a Roth IRA.  One of these strategies is known as a “Backdoor Roth IRA” and is described below.

Backdoor Roth IRA Approach:
If you make too much money to contribute to a Roth IRA, you can make a non-deductible contribution to a traditional IRA.  A traditional IRA does not have an income ceiling for contributors, like a Roth IRA does.  Once the funds are in the traditional IRA, convert the traditional IRA to a Roth IRA.  Since the amount you contributed to the traditional IRA was non-deductible, when you convert, you will not have to pay taxes on that conversion (assuming their were no earnings on the investments between the time you funded the traditional IRA and converted to the Roth IRA).

The Catch:
When you convert your traditional IRA to a Roth IRA you do not get to pick which contribution (non-deductible or deductible) gets converted.  In fact, the IRS requires you to take into account ALL your IRA holdings when doing a conversion.  What does this mean?  It means if you have $5,000 in non-deductible traditional IRA contributions, and $15,000 in other pre-tax traditional IRA contributions, then you have 25% of your traditional IRA assets treated as non-deductible.  When you do a conversion, even if you only convert $5,000 of the $20,000, 75% of it will be taxable and 25% will not be taxable. 

The real disadvantage comes when you have existing pre-tax traditional IRA balances and you are in a high-tax bracket.  If you are in a high-tax bracket, you’ll inadvertently have to pay taxes on a prorated portion of these assets balances at that higher tax rate.  This may negate the benefits of the backdoor strategy.

The Work Around:
If you currently have an employer-sponsored 401(k), 403(b), etc, you may have the option of transferring your existing pre-tax traditional IRA assets into this account.  Once the assets are in this account, then you can proceed with the backdoor strategy.  The IRS does not include assets in employer-sponsored plans as assets that need to be aggregated for conversion purposes.  In other words, if the assets do not show-up in IRA accounts then they won’t be included in the calculations of assets that are taxable upon conversion.

The Complication:
The complication of a backdoor Roth IRA strategy arises with the possibility of the IRS applying the “Step Transaction” doctrine to the contribution.  The step doctrine, is best described by Michael Kitces in his article “Backdoor Roth IRA Contributions – Strategy or Step Transaction Abuse?” available here:

The following paragraph from his article highlights the risk:

“The step transaction doctrine is the legal principle that a series of related steps in a transaction should be taxed based on the overall economic nature of the transaction, not “just” based on the separate individual steps. In the context of the contribute-then-convert strategy, the step transaction doctrine would examine the overall result of the transaction – dollars came out of a taxable account and ended up in a Roth IRA – and tax it according to the substantive result that occurred: that the taxpayer constructively made a contribution to a Roth IRA. After all, the taxpayer contributed to the non-deductible IRA for the sole purpose of converting it to a Roth IRA, and did those two steps together for the sole purpose of getting a new annual contribution into a Roth IRA. In the end, the net result is that the taxpayer constructively made a Roth IRA contribution. According to the step transaction doctrine, if that’s “really what happened” then the IRS can call a spade a spade, and tax it accordingly.”

The problem here, as Kitces points out, is that the step transaction doctrine is enforced on a case-by-case basis.  So, while people may take advantage of this strategy, their may be an opening for the IRS to enforce the step transaction rules and require investors to pay taxes on their contributions.  It may not be likely, but it is possible and as more people employ the strategy, the odds increase that it will get further IRS scrutiny in the future.