Backdoor Roth IRA: Have you heard of it?

Backdoor Roth IRA: Have you heard of it?

Ever heard of a backdoor Roth IRA?  Or for that matter, have you ever heard of a MEGA backdoor Roth IRA?

How does this work and is it legal?

The concept of the backdoor Roth IRA is designed for persons who have income too high to fund a regular Roth contribution. Remember that with a Roth, it’s not a question of whether or not the contribution is tax deductible (which it’s not). The issue is whether you can make a contribution at all. That issue is determined by the taxpayer’s modified adjusted gross income (MAGI). For 2019, a married couple filing jointly starts to lose the ability to fund a Roth IRA when MAGI reaches $193,000. By the time MAGI reaches $203,000, no Roth contribution is allowed. For other filing statuses, the reduction for funding a Roth begins at MAGI of $122,000, and by the time MAGI reaches $137,000, no contribution is allowed.

Taxpayers with earned income (and who are under age 70½) can always fund a traditional IRA because it’s not limited by income. Rather, the deductibility of the traditional IRA is impacted by income, pension availability, etc.

So where does the backdoor Roth come into play? There are several steps to the process:

Step 1: Ensure You Don’t Have Any Other Pre-Tax IRA Accounts

This is key! Typically a backdoor Roth won’t work for taxpayers with large regular IRA accounts, like from a previous employer’s rollover of a 401(k). Professionals are encouraged to look at the instructions for Form 8606 to see how the backdoor Roth in essence blows up when large regular IRA accounts exist. One thought that may help to alleviate this issue is for your client to move large regular IRA assets to their employer’s 401(k), or other plan, if their employer’s plan permits reverse IRA rollovers.

Step 2: Make A Contribution to a Traditional, Non-Deductible IRA (Remember, your client’s income is too high to fund a Roth IRA)

Establish and fund a traditional IRA and contribute up to $6,000 (the 2019 limit) or $7,000 for taxpayers age 50 or older as a non-deductible contribution. It may make sense to also establish, but not fund, a Roth IRA at the same time to make the transition seamless.

Step 3 – Convert the Traditional IRA to the Roth IRA

After the deposit settles with the traditional IRA, instruct the firm holding the account to get the process underway to convert the traditional IRA to Roth. The sooner this is done, the better, as any earnings in the traditional IRA becomes taxable when converted to Roth. This is really where the rubber meets the road.  While, as I mentioned above, contributions to Roth IRAs are limited by your client’s income, conversions are not limited by income. The conversion is then reported on Form 8606. Assuming there were no other traditional IRA assets to contend with, the conversion will be tax free. While this may seem as though we are skirting the tax laws, Congress has ruled these actions are legal.

So what is a Mega Backdoor Roth IRA?

The Mega Backdoor Roth uses the ability of taxpayers to make after-tax contributions to a 401(k) plan, which are treated like a traditional IRA. In order for this to work, the first key step is to have your client participate in an employer plan that permits after-tax contributions. Not Roth 401(k) contributions, just after-tax contributions. This would also apply to Solo-401(k) clients.

In order to do a Mega Backdoor Roth IRA, the 401(k) plan needs to offer:

• After-tax contributions above and beyond the $19,000 (plus catch up for 50+ taxpayers) pre-tax contribution limits
• In service distributions or non-hardship withdrawals

If the plan meets these rules, the client can max out their 401(k) with after-tax contributions up to the contribution limit each year. They can then transfer that money to a traditional IRA, and do the same process as a Backdoor Roth IRA. Watch out – the maximum contribution allowed from ALL sources (the client plus their employer match) is limited to $56,000 in 2019 ($62,000 for age 50+) or 100% of compensation, whichever is lower.

The bad news is that very few employers have plans which allow both after-tax contributions and in service distributions. Advise your clients to check with their benefits manager (and not their buddy in the next cubicle) before taking this on.

So How Do We Accomplish this ‘Mega’ Production?

The process for doing a Mega Backdoor Roth IRA conversion is very similar to a regular backdoor Roth, just substitute the after-tax 401(k) for a traditional IRA.

1. Maximize After-Tax 401(k) Contributions (assuming this is possible)

Remember, that a key here is to make after-tax 401(k) contributions and not straight-up ROTH 401(k) contributions

2. Transfer the After-Tax Portion to the Roth IRA

The employer must allow in-service non-hardship withdrawals for this to work, as mentioned before. This concept can work if the client waits until they terminate employment, but then they can run into the earnings problem as in the regular backdoor Roth where the earnings (but not the contributions) are taxable.

Alternative:  If your client’s plan allows for in-service Roth 401(k) conversions (sometimes referred to as Designated Roth accounts), your client may be able to simply contact the 401(k) provider and rollover the after-tax portion to the Roth account in the 401(k).

Conclusion

I have to admit that in the past I was not a fan of the whole Roth IRA concept. Imagine, passing on a tax deduction now for a promise from the federal government of no tax down the road. However, I have become a convert (pardon the pun). This is especially true now that we have the TCJA, which seems to support the notion that it doesn’t make as much sense to push off taxation to some point down the road when tax rates today may be in fact the lowest we may ever see. I think most of you would agree, and would be willing to make sizeable bets that somewhere down the road, federal taxes are going to be higher—it’s just common sense.  Also, we see retirees today who actually are earning more in retirement than they did during their working years. So the whole concept that I have preached about for the last nearly 40 years — deferring taxes to a later date —may in fact not be working out as projected.

I don’t expect all of you to buy in to my thinking in this instance, but I hope this narrative gives you some discussion points to consider with your clients.  After all, as I’ve stated many times before, you are the most trusted advisor your client has.  In the final analysis, it’s the client’s decision to make; your job is to present as many reasonable alternatives as possible for that client to be able to reach an informed decision.

by Tom O’Saben, EA