Following up on an article that appeared in the BNN Newsletter last October, this blog post will focus on an important and increasingly popular tax planning tool involving Roth conversions.
Many high income individuals are ineligible to directly make Roth IRA contributions because their modified adjusted gross income (MAGI) is too high. For 2014, MAGI in excess of $191,000 for married individuals filing jointly, and $129,000 for single individuals, means that these individuals would not be eligible to contribute directly to a Roth.
Is there an alternative means by which these high income individuals can still make a Roth contribution? The answer to this question is “yes”, but it is critical that the individual get complete tax advice on the transaction, as there can be some unintended tax consequences in certain situations. While there are income limitations on directly making contributions to a Roth IRA, since 2010, there are no income limitations on converting an existing, non-Roth IRA, to a Roth. Because there is no income limitation on Roth conversions, the “back door” Roth contribution has gained in popularity.
The back door Roth technique involves making a nondeductible contribution to a traditional IRA and immediately converting it to a Roth IRA. Because the contribution to the traditional IRA is nondeductible, converting those assets to a Roth would result in no income tax upon conversion. An often overlooked aspect of this technique is that IRS rules don’t allow a taxpayer to hand select which IRA assets he or she wishes to convert. If an individual has other IRA accounts, there is the potential for a tax surprise if the individual isn’t careful. Let’s take a look at two examples:
Angela, a single taxpayer, has MAGI of $150,000 for 2014. Angela has no other IRA assets. During 2014, she opens a traditional IRA account and makes a $5,500 non-deductible contribution. She immediately converts that traditional IRA to a Roth. This transaction will result in no income tax consequence.
Christine, a single taxpayer, has MAGI of $150,000 for 2014. In 2013, Christine changed jobs and decided to roll her 401(k) balance of $100,000 into an IRA. Christine heard from her friend Angela of a technique that would allow her to make a Roth contribution even though her income is above the limit. Thinking this is an excellent idea, she makes a $5,500 non-deductible contribution to an IRA, and immediately converts it to a Roth. On the date of the conversion, the balance in her rollover IRA is $104,500. She is surprised to find out from her CPA that only 5% ($275) of her $5,500 conversion will be tax-free. She will owe income tax on the remaining $5,225 conversion amount.
Here’s why: After making the $5,500 nondeductible contribution, Christine now has a grand total of $110,000 in IRA assets. Of the $110,000, only $5,500, or 5%, is comprised of non-deductible contributions. The other $104,500, or 95%, is made up of the rollover IRA. Because IRS rules don’t afford you the choice to just convert the nondeductible IRA, a pro rata portion of all IRA assets is deemed to be converted, which results in 95% of the conversion being taxable.
So how can an IRA owner avoid this undesirable result? One method is to roll the rollover IRA back into a 401(k) plan or other qualified plan. In Example 2 above, if Christine rolls the $104,500 IRA into her new employer’s qualified plan before doing the back door conversion, her only IRA assets after the conversion will be from the $5,500 nondeductible conversion, and the conversion will be tax-free. Note that this technique will not work if Christine’s new employer’s plan is a SEP-IRA or a SIMPLE-IRA.
While the back door Roth contribution can be a valuable technique for some taxpayers, it is critical to get complete tax advice before proceeding.