TRUST AND ESTATE

Back Door Roth: White Stilton Gold Cheese or Just a Mousetrap?

By David C. Valente

David C. Valente discusses the intricacies of a “Back Door Roth” contribution and what taxpayers might be eligible for this potentially effective and tax-efficient planning opportunity.

© David C. Valente 2022 | All Rights Reserved

The primary appeal of Roth IRAs is the potential for tax-free growth and tax-free “qualified distributions”. Though understandably alluring, the opportunity to make contributions to such a plan is limited. There are generally four methods by which an individual may contribute to a Roth: (i) direct annual contributions to a Roth IRA; (ii) employee elective deferrals to a Roth 401(k); (iii) a Roth conversion; or (iv) a so-called “Back Door Roth” contribution.

In order for a distribution to be qualified, it must be taken after a taxpayer1 reaches age 59 ½ and a five-year holding period (the “5year rule”) has been satisfied. The 5-year rule is measured from the first day of the year in which the taxpayer established and contributed to any Roth IRA. If the taxpayer has not met the 5-year rule and she is younger than age 59 ½ at the time of a distribution, she will be subject to income taxes on withdrawals in excess of basis (“earnings”) and a 10% early withdrawal penalty on such earnings, whereas if she is 59 ½ or older, the 10% penalty is avoided. Alternatively, if she has satisfied the 5-year rule but is under age 59 ½ at the time of distribution, earnings will be subject to income taxes and the 10% penalty. There are exceptions to the early withdrawal penalty, such as withdrawals made as a result of death or disability, for a first-time home purchase, or certain college, birth or adoption expenses. Unlike a Traditional IRA, there are no Required Minimum Distributions (“RMDs”) for Roth IRAs during a taxpayer’s life and contributions to a Roth IRA are not deductible to the taxpayer for income tax purposes.

With regard to direct annual contributions, a taxpayer must be eligible to contribute, and contributions must come from compensation income, including, without limitation, wages, salaries, commissions, professional fees, bonuses, other amounts received for personal services, taxable alimony, combat pay, jury fees, and, for a self-employed person, the net employment income from the business. Payments from IRAs, company retirement plans, social security benefits, and other passive sources of income (e.g., royalties, interest income, capital gain income, life insurance proceeds, disability and unemployment payments) do not constitute compensation income. There is no age restriction on Roth IRA contributions, the deadline for which is April 15 of the year following the contribution year, even if the taxpayer obtains an extension to file her income tax returns. Depending on household income, the taxpayer’s Roth IRA contribution may be limited if not eliminated entirely. In 2022, a single filer may make the maximum contribution ($6,000 in 2022 if the taxpayer is under age 50, $7,000 if she is age 50 or older) if her Modified Adjusted Gross Income (“MAGI”) is under $129,000. If her MAGI is $129,000$139,999, she can contribute a reduced amount, and if her MAGI is $144,000 or more, she may not make any contribution to a Roth IRA. When a couple files as married filing jointly, the non-working spouse can contribute so long as the working spouse has sufficient earned income to cover both contributions and the couple meets other eligibility criteria.

In order to contribute to a Roth 401(k), the employer-sponsored plan must allow for designated Roth employee elective contributions, which are made with after-tax dollars. In 2022, the applicable contribution limit is $20,500 (plus another $6,500 for employees over age 50). Unlike direct annual contributions to a Roth IRA, there is no income limitation with respect to a contribution to a Roth 401(k). RMDs do apply, subject to certain exceptions, once the employee has attained age 72 (age 70 ½ if she reached age 70 ½ before January 1, 2020), though she could roll the balance of the Roth 401(k) into her Roth IRA to avoid subsequent RMDs. Under “SECURE Act 2.0”, proposals include the following: (i) the catch-up contribution limit for those ages 62 through 64 is increased to $10,000, beginning in 2024 and indexed for inflation; (ii) effective Jan. 1, 2022, all catch-up contributions to employer-sponsored qualified retirement plans would be subject to Roth tax treatment; and (iii) plan sponsors would have the option of permitting employees to elect that some or all of their matching contributions to be treated as Roth contributions for 401(k) plans, in which case employer matching contributions designated as Roth contributions would not be excludable from employees’ gross income.

A “Roth conversion” refers to transferring all or a portion of the balance of one’s Traditional, SEP or SIMPLE IRA (herein “Traditional IRA” in this article) or qualified employer sponsored retirement plan – such as a 401(k), 403(b), or governmental 457(b) – into a Roth IRA. The converted amount will be included in taxpayer’s ordinary income, though not subject to the 10% penalty. Since January 1, 2010, the restriction that prevented individuals with MAGI exceeding $100,000 from converting a pre-tax IRA, or other qualified retirement plan, to a Roth IRA was eliminated. Once converted, distributions are qualified, and therefore tax-free and penalty-free, so long as the 5-year rule has been satisfied and the taxpayer has attained age 59 ½ (or one of the other exceptions applies). If the taxpayer is required to take a RMD in the year of conversion, she must do so prior to such conversion. Assuming the taxpayer has sufficient liquidity with which to pay the income taxes arising out of the conversion, a Roth conversion presents a significant opportunity for a taxpayer who is otherwise ineligible to directly contribute to a Roth IRA, to convert an pre-tax retirement plan, not limited in size, to a Roth IRA.

A good candidate for a “Back Door Roth” is an individual with MAGI exceeding the applicable income limitations, who wishes to maximize tax-free growth opportunities. First, the taxpayer would need to contribute an amount up to the maximum ($6,000 in 2022 if the taxpayer is under age 50, $7,000 if she is over age 50) to a non-deductible Traditional IRA. Shortly thereafter, taxpayer would convert such IRA to a Roth, and assuming the value of the account does not appreciate between the contribution and the conversion, the conversion would trigger no income taxes, and post-contribution earnings would grow tax-free. The Joint Committee on Taxation’s “Joint Explanatory Statement of the Committee of Conference” (with reference to the Tax Cuts and Jobs Act of 2017) mentions the Back Door Roth strategy favorably four times. However, the taxpayer and her advisors should be aware of potential pitfalls., such as the pro rata rule.

The pro rata rule arises where a taxpayer holds pre-tax IRA assets, in the year of conversion, other than the IRA she wishes to convert. The IRS does not permit the taxpayer to treat the conversion as coming solely from the non-deductible IRA. Instead, taxpayer must include a portion of the conversion in her taxable income, based on the pro-rata value of other pre-tax IRA assets. In making this determination, traditional IRAs, SIMPLE and SEP IRAs are aggregated. 401(k), 403(b) or similar employer retirement plans, as well as existing Roth IRAs, are not aggregated. The converted amount is included in gross income, except to the extent (if any) it represents basis. To determine the non-taxable portion, the taxpayer needs to multiply the converted amount by a fraction, the numerator of which is the basis in all her traditional, SIMPLE and SEP IRAs, and the denominator of which is the (aggregate) balance of all of such IRAs (such balance based on the year-end value of all such IRAs, including any amounts distributed during that year). Among other things, Form 8606 is used to report nondeductible contributions a taxpayer made to traditional IRAs, as well as conversions from traditional, SEP, or SIMPLE IRAs to Roth IRAs.

As an example, consider Jeff, age 48, who is single with MAGI of $175,000. Jeff has a 401(k) worth $1 million, but no IRAs. He has sufficient compensation income to allow him to make the maximum IRA contribution, but his income is too high to permit him to make a direct Roth IRA contribution. Assume further that he contributes $6,000 in June 2022, as an after-tax, non-deductible contribution to a newly-established Traditional IRA, and Jeff converts that IRA on December 31, 2022, by which time it has grown to $6,200. Jeff’s tax preparer would multiply the converted amount ($6,200) by a fraction, i.e., Jeff’s basis in all IRAs ($6,000), divided by the year-end aggregate balance of IRAs ($6,200.) $6,200 x ($6,000/$6,200) = $6,000, which is the amount excluded from taxable income; the remaining $200 is taxable. In this case, Jeff’s Back Door Roth contribution was successful.

If instead Jeff’s $1 million 401(k) were a (pre-tax) Rollover IRA, the converted amount ($6,200) would be multiplied by a much different fraction, i.e., $6,000 / $1,006,200, producing a result of $36.97, which is the amount excluded from income. The remaining $6,163.03 would be taxable and a clear example of an unsuccessful Back Door Roth contribution. Had Jeff been counseled properly, he would have rolled his pre-tax IRA into his 401(k) (assuming the employer plan permits incoming transfers, which most do). Because employer retirement plans are excluded from the denominator of the fraction, the balance of funds rolled into his 401(k) plan would not have been included in the calculation, and the strategy would have been successful.

Clients considering, and professional advisors suggesting, a Back Door Roth contribution should be mindful of the step-transaction doctrine, the roots of which are traced to the U.S. Supreme Court’s decision in Gregory v. Helvering, 293 U.S. 465 (1935). The doctrine allows one or more steps in an overall transaction to be ignored, or for multiple steps in an overall transaction to be combined and treated as a single step. Though there is no bright line rule as to how long a taxpayer should wait, many conservative practitioners suggest allowing a year to elapse between the time of the contribution and the conversion, whereas more aggressive practitioners consider one month to be sufficient. If structured and implemented properly, the Back Door Roth IRA contribution can be an effective and tax-efficient planning opportunity.

Endnotes

1. IRC § 72(t)(2) refers to an “employee,” which includes a participant, and in the case of an individual retirement plan, the individual for whose benefit such plan was established, but this article shall simply use the term “taxpayer.”

SUMMER 2022 eReport