Beth, as I’ll call her, is a new client, and I find to be a really fascinating woman. She lives in Sandwich, has been a single mom for 25 years, raised two beautiful and successful daughters on a very limited income, and at age 45 started her own small but thriving and growing property management business. Beth just turned 50 this year. She’s pulling in significant income, and she’s self-funding her retirement as well. She’d like to do more. Recent guidance from the IRS and Congress may point the way. It hinges on the legitimization of a process known as the “Back Door Roth” strategy.
The Roth IRA is a tax-advantaged retirement savings tool. A taxpayer can contribute up to $5,500 of earned income per year to a Roth IRA (or, if you’re over 50, as Beth is, you can “catch up” with annual contributions of $6,500). Roth IRAs do not have Required Minimum Distributions (RMDs) and contributions can be made to them even after a taxpayer turns age 70½, provided there is earned income.
Roth IRAs are funded with post-tax income, and distributions are tax-free when you follow the rules. Therefore, Roth IRAs are popular savings tools for investors who expect their tax rate to be higher during retirement than their current rate. Investors early in the wealth accumulation phase of their life often like Roth IRAs for this reason, as do others who want to lower their tax profile in retirement. Some investors even choose to do a Roth Conversion, which is a process that converts a Traditional IRA to a Roth IRA. Converting a Traditional IRA funded with pre-tax funds (contributions for which a taxpayer has taken deductions) increases taxable income in the year of the conversion on the amount converted, but then allows that money to grow tax-free going forward.
Why doesn’t everyone contribute to Roth IRAs rather than Traditional IRAs? Well, one reason is that there are income limits to Roth IRA contributions. If you make too much, you can’t contribute to a Roth IRA. In 2018, the Adjusted Gross Income (AGI) phase-out range for taxpayers who want to contribute to a Roth IRA is $189,000 – $199,000 for married couples filing jointly, or $120,000-$135,000 for individuals.
If you earn under those thresholds, you are in pretty good shape. But what if you don’t?
So, let’s talk about the “Back Door Roth.” You see, while there are income limits on contributions to a Roth IRA, there are no income limits for making non-deductible Traditional IRA contributions. And ever since a tax reform package passed in 2010, there have been no income limits on Roth IRA conversions.
As a result, high-income earners who can’t ordinarily contribute to a Roth IRA can follow a two-step process to achieve the same results. First, they make a non-tax-deductible contribution to a Traditional IRA, then convert that IRA to a Roth. That is, in essence, a “Back Door Roth.”
While Back Door Roth conversions have been popular for a while, their legitimacy has been a bit of a gray area thanks to an absence of guidance from either the IRS or from Congress. But earlier this year, a conference committee report by Congress about the Tax Cuts and Jobs Act included footnotes that expressly allow Roth conversions to happen. More specifically, a footnote in the Congressional report says, “Although an individual with AGI exceeding certain limits is not permitted to contribute directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA.”
There it is in black and white. That’s about as unequivocal a thumbs-up as you can get.
For Beth, whose income exceeds the AGI phase-out range, this strategy presents an opportunity. She’s already maxing out a self-funded 401(k) plan, but she has the funds to save more. She can open a new Traditional IRA, make a non-deductible contribution of up to $6,500 and then convert it to a Roth in quick succession. Assuming there are no earnings in the Traditional IRA between the time of the contribution and the conversion, Beth will not owe tax on the conversion.
But bear in mind that a Back Door Roth can have tax implications. As mentioned above, money converted from a pre-tax Traditional IRA is reported as ordinary income in the year of the conversion. The IRS views any money a taxpayer has in IRAs (except Roth IRAs) as one account and if a taxpayer has made both deductible and non-deductible IRA contributions, any money converted is taxed pursuant to the Pro-Rata Rule, which can limit the attractiveness of a Back Door Roth for some taxpayers.
Fortunately, Beth does not have pre-tax Traditional IRA money, so the Pro-Rata Rule does not affect her. She figures she has about 15 years to retirement. If she continues to perform an annual Roth conversion every year until she’s 65, Beth will have contributed about $97,500. Based on an assumed 7% rate of return, Beth could anticipate having $192,706 of additional tax-free income in retirement if she holds tight to her strategy.
Of course, Beth may occasionally need to course-correct and reassess her strategy based on income, investment goals, and life plans. Things change, sometimes in an instant. But Back Door Roth IRA conversions could be a vital component of her savings and investment strategy going forward, especially with the tacit blessing of the IRS and Congress.
That being said, as Congress giveth, Congress taketh away too – one key provision in the Tax Cuts and Jobs Act eliminated taxpayers’ ability to “recharacterize” Roth IRA conversions back to traditional IRAs, which is sometimes done (among other reasons) when there is significant market loss in a Roth IRA since the conversion.
Taxpayers can still recharacterize 2017 Roth IRA conversions, but only until October 15, 2018, so time is running out. A Roth IRA conversion made on or after January 1, 2018, cannot be recharacterized.
As with any change to your investment or tax strategy, performing a Roth IRA conversion is something that you should work with trusted retirement specialists to do, as there are tax implications and other practical considerations you must be wary of. But under the right circumstances, Back Door Roth IRA conversions can be an appropriate tool to help investors save more for their retirement.
Be vigilant and stay alert, because you deserve more!
Have a great week.
Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, a wealth management firm with offices is Falmouth, Duxbury, and Mansfield. Jeff can be reached at firstname.lastname@example.org.
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