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Back Door Roth IRA: How To Avoid The IRA Aggregation And Step Doctrine Rules



By Michael Baker, CFP® - Manager of Financial Planning

With the passage of the Protecting Americans from Tax Hikes Act of 2015 Congress re-enacted numerous tax-planning provisions including state and local sales tax deductions, the American Opportunity Tax Credit, and rules allowing for qualified charitable distributions directly from an IRA to a charity for those over age 70½. What we don’t see in the legislation is any mention of the “Back door Roth strategy.” With this in mind, high-income individuals who aren’t eligible to contribute to a Roth IRA in the traditional manner are—at least for one more year—permitted to do a Roth conversion.

IRS rules prohibit contributions to a Roth IRA for individuals with an annual adjusted gross income (AGI) of $131,000 ($193,000 for married couples). This does not preclude these individuals from contributing to a traditional IRA, though the deductibility of these contributions will vary depending on whether they participate in an employer-sponsored retirement plan. Under the Internal Revenue Code, as adjusted by the Protecting Americans from Tax Hikes Act of 2015, there are no income restrictions on Roth conversions. Consequently, anybody who funds a traditional IRA, whether it’s pre-tax or after-tax, is able to convert that traditional IRA to a Roth IRA.

Taken together, those with higher income may not be allowed to make Roth IRA contributions, but there is nothing precluding them from sneaking in the “back door” by converting an after-tax traditional IRA to a Roth IRA. Of course there are several rules that stand between high-income individuals and a successful use of this strategy.

While the “back door” strategy is fairly straight forward, there are rules that can slam that door shut if the execution of the strategy is not buttoned up. Internal Revenue Code Section 408(d)(2) relates to what is known as the IRA aggregation rule. This rule states that for any individual with multiple IRAs the total value of all of those IRAs will be considered when calculating the tax consequences of any distributions from an IRA (including distributions for a Roth IRA).

Often times IRAs contain dollars that haven’t been taxed; for instance, an IRA rollover from an old 401(k) plan. When this is the case, and these pre-tax IRAs are aggregated with the new after-tax IRA, the distribution for a Roth conversion will be treated as made on a pro-rata basis from the multiple accounts. The net result in such cases is that some of those dollars will be taxed even if they are distributed exclusively from an after-tax IRA!

Example: John has $450,000 of existing IRA assets, accumulated by rolling over 401(k) accounts from former employers. John’s income exceeds the IRS limits for making a contribution to a Roth IRA, but wishes to make a $5,500 contribution to a non-deductible IRA and convert only the $5,500 from the newly established IRA into a Roth IRA.

Due to the IRA aggregation rule, John is not permitted to convert only the $5,500 non-deductible IRA contribution. He must treat the $5,500 conversion from any account as a partial conversion of all of his IRA assets.

With this in mind, if completes a $5,500 Roth conversion, the after tax portion of that conversion will only total $5,500 / $455,500 = 1.21%. The net result of his $5,500 Roth conversion will be $66.42 of after-tax funds that are converted, meaning that $5,433.58 of the conversion will be taxable to John!

After the conversion is completed, John will be left with a $5,500 Roth IRA and $450,000 of pre-tax IRAs that still have $5,433.58 of associated after-tax contributions (the remaining portion of the $5,500 non-deductible contributions that were not converted).

While the aggregation rule considers all IRAs (excluding inherited IRAs) it does not include employer retirement plans (401(k), 403(b), etc.). The fact that these employer plans aren’t included in the aggregation rules once again cracks open the back door. Many—though not all—401(k) plans provide the option to roll over assets into the plan. In such cases, pre-tax IRAs can be rolled into an employer retirement account, thus removing the assets from the aggregation equation. Suddenly all that remains from an aggregation standpoint is the new after-tax IRA.

The second consideration when it comes potential problems with the back door IRA strategy is what is known as the “step transaction doctrine.” The premise behind this is simple, the Tax Court is considering the intention not the process. Accordingly, if the contribution to an after-tax IRA is done simultaneously with the conversion of that IRA to a Roth IRA, what really happened in the Tax Court’s view was nothing more than a contribution to a Roth IRA. The Tax Courts ruled unfavorably on this in the 1935 Gregory v. Helvering. If the transactions are done in close succession, and that is determined by the IRS and Tax Court to be solely for the purpose of contributing to a Roth IRA, the individual may be hit with a 6% excess contribution penalty!

In order for the back door Roth IRA strategy to work it is essential that each step of the process is completely legitimate. This can be accomplished by increasing the time between opening the IRA and converting it to a Roth IRA. This gets tricky because there are no hard-and-fast rules on how long is long enough to wait. By establishing the after-tax account in June 2016 and converting it to a Roth in December of 2016 the case that each step served its own purpose can be made easier.

The last, simplest, and most important consideration of all is that there not be any records (personal or financial professional) that indicate any intention of doing a “backdoor Roth IRA.” This will almost certainly slam that back door shut if the Tax Court Comes across it. Communications with and files of your financial professional are discoverable documents in such proceedings!

There is no guarantee that this strategy will continue to be available on an ongoing basis. The presidential election looms large over all things political and financial. If the primaries are any indication of the current state of our political system, it seems that everything is on the table at this point; be it cuts or expansion! In short, strike while the iron is hot!


Disclosure: This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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