Understanding a ‘backdoor’ Roth IRA

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Q. How does a “backdoor” Roth work? I’m single and I earn more than $140,000. I save the max to my Thrift Savings Plan (TSP) in its Roth option. I have no IRA. I would like to make a nondeductible IRA contribution and then immediately convert it to a Roth IRA. Can I do this?
— Hopeful

A. Let’s go over the rules.

Individuals with modified adjusted gross income (MAGI) between $120,000 and $135,000, and couples married filing jointly with MAGI between $189,000 and $199,000, are limited in what they can contribute to a Roth IRA.

“Income above those amounts makes them ineligible to make any contribution,” said Abby Rosen, a certified financial planner with RegentAtlantic in Morristown. “Your income of $140,000 as an individual means you’re not eligible to make Roth IRA contributions directly.”

A “backdoor” Roth is as you described. One would make a contribution to a traditional IRA and then convert it to a Roth. You’d need to pay taxes on any earnings while your funds were in the traditional IRA, but if you make the conversion quickly, you’ll probably have few gains to worry about.

The conversion isn’t always simple, Rosen said.

“One caveat to making backdoor Roth IRA contributions is if you have any pre-tax IRA money – including SEP and SIMPLE IRAs – all IRA money, pre-tax or non-deductible, will be looked at together when determining tax consequences of converting,” Rosen said. “Employer sponsored retirement plans such as 401(k)s, 403(b)s and your Thrift Savings Plan are excluded. Spouse’s assets are excluded too.”

She offered this example:

Let’s say you already have $16,500 in pre-tax money in an IRA. You open a new IRA and make a nondeductible contribution of $5,500. Your total IRA assets are now $22,000, of which, 25 percent is non-deductible. If you convert that $5,500 into a Roth IRA, only $1,375 (25 percent of $5,500) will be tax free and the remaining $4,125 will be taxable as ordinary income.

Another caveat is the timing of making that conversion from traditional IRA to Roth IRA, Rosen said.

“What you are specifically wondering about is what’s called the step transaction doctrine, and if or when it applies to backdoor Roth IRA contributions,” Rosen said. “Per IRS memo 200826004, `Under the step transaction doctrine, a series of transactions designed and executed as parts of a unitary plan to achieve an intended result … will be viewed as a whole regardless of whether the effect of so doing is imposition of or relief from taxation.’”

“It would seem therefore, making a contribution to a traditional IRA, then soon after converting to a Roth IRA, would be two parts of one plan – trying to get around the income limits of making Roth IRA contributions – thereby making the “backdoor Roth IRA contribution” prohibited,” Rosen said.

She said in the past, there was never any guidance from the IRS or Congress on specific timing to ensure making IRA contributions, then converting, was allowed. She also said she hasn’t heard of the IRS enforcing the step transaction doctrine.

“The good news, with the recent tax reform, Congress officially stated individuals with income exceeding the limit to make contributions directly to a Roth IRA, are allowed to make contributions to a traditional IRA, and then convert,” she said. “This statement takes the issue of timing away.”

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