Back Door Roth IRA Contributions

Question:  Even though I am ineligible to make a Roth IRA contribution, can I make a non-deductible IRA contribution and then convert this amount to a Roth IRA?

Answer:  You describe an interesting strategy which permits many taxpayers who are ineligible to make Roth IRA contributions to indirectly accomplish the same. There are some issues you must consider before embarking on what is sometimes referred to as a “back-door” Roth IRA. 

Roth IRAs allow eligible persons to make non-deductible contributions subject to the same limitations that apply to conventional IRAs, $5,500 for the calendar year 2016 with an additional $1,000 contribution permitted for individuals who have attained age 50.  Like conventional IRAs, earnings on Roth IRAs are not subject to income tax.  Two significant additional benefits result from Roth IRAs.  Unlike conventional IRAs, there is no requirement that Roth IRA owners commence lifetime distributions upon attaining age 70 ½.  In addition, Roth IRA distributions which satisfy certain requirements are not subject to income tax. 

Income limits are imposed on taxpayers wishing to make Roth IRA contributions. For 2016, the allowable amount of Roth IRA contributions begins to phase out for a single income taxpayer once the individual’s modified adjusted gross income reaches $117,000.  For married persons filing joint income tax returns, the amount of allowable Roth IRA contributions begins to phase out once the couple’s modified adjusted gross income reaches $184,000. 

The amount of your income notwithstanding, you are permitted to make non-deductible contributions to a traditional IRA. Following a non-deductible IRA contribution, you can transfer the amount in your traditional IRA to a Roth IRA.  Effectively, you are making a Roth IRA contribution despite the fact that your income exceeds the foregoing thresholds.  Only the amount transferred to the Roth IRA in excess of the non-deductible contributions you have made is taxable.  If the transfer is made shortly after the non-deductible contribution is made to the traditional IRA, there will be little if any income tax on the transfer. 

Be mindful that the transfer from a traditional IRA to a Roth IRA is deemed to consist of a pro rata portion of the funds you hold in all of your IRAs.  If you maintain a traditional IRA, the transfer to the Roth IRA will consist of a pro rata portion of deductible contributions, non-deductible contributions and earnings in all of the IRAs you hold. Even if you have maintained the non-deductible contributions in a segregated account and use only those funds for the transfer, the transferred amount will be subject to the pro rata rule.  The taxable portion will be computed based on that portion of the transfer attributable to deductible contributions you have made to your IRAs and your IRA earnings.

 One means of circumventing this restriction is to transfer amounts in your traditional IRA which originated from deductible contributions and any corresponding earnings to a qualified retirement plan such as a profit sharing or 401(k) plan that permits IRA rollovers.  By then making a nondeductible contribution to a traditional IRA and leaving yourself in a situation where you hold only traditional IRAs with non-deductible contributions, a transfer to a Roth IRA can be made with likely minimal consequence.

The IRS has not directly sanctioned the backdoor IRA strategy meaning a non-deductible contribution to a traditional IRA followed by an immediate transfer to a Roth IRA could potentially be attacked by the Service.  Allowing some meaningful time to lapse before the transfer may defuse this argument and, in today’s low-interest environment, cost little in the way of taxes on likely minimal account earnings.

 

The Tax Corner addresses various tax, estate, asset protection and other business matters.  Should you have any questions regarding the subject matter or if you have questions you want to be answered, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfnr.com.