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Backdoor Roth IRA Contributions - Part I

1/9/2014

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What is Backdoor Roth IRA Contribution
As part of the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), income limits on Roth conversions were repealed, starting in 2010.  However, while TIPRA removed income limits for Roth conversions, it did not eliminate the income limits for new Roth contributions. 

As a result, a new creative use of Roth conversions opened up: just contribute to a non-deductible traditional IRA, and then complete a Roth conversion immediately thereafter.  Since neither transaction individually has a contribution limit, you can get money into a Roth IRA each year, regardless of the still-remaining income limits on Roth contributions. 

There's just one problem: the IRS can still call a spade a spade, and the rising abuse of this "loophole" may bring about its permanent end.

Complication I. IRA Aggregation Rule
There is a complication of the strategy - the IRA aggregation rule under IRC Section 408(d)(2).  The rule stipulates that when a Roth conversion occurs, the taxpayer must calculate the income tax consequences of a Roth conversion by aggregating together all of the taxpayer's IRAs; as a result, other pre-tax IRA funds can distort the tax consequences of the contribute-then-convert strategy. 



An Example
Assume Joe contributes $5,000 to a non-deductible IRA with the intention of converting it.  However, Joe also has a $150,000 pre-tax IRA, the accumulation of several prior 401(k) rollovers, and $12,000 of non-deductible contributions from many years ago.  When Joe converts his newly created $5,000 non-deductible IRA, he cannot simply convert at a tax cost of $0.  Instead, the IRA aggregation rule applies.  


His total non-deductible contributions are $12,000 + $5,000 = $17,000, and his total IRAs are $150,000 + $5,000 = $155,000.  Accordingly, when Joe converts the $5,000 non-deductible IRA contribution, the portion that is non-taxable will be $17,000 / $155,000 = 10.97%, or $549.  The remaining $4,451 will be taxable income, due to the application of the IRA aggregation rule; this result occurs even if all the new non-deductible contributions are made to a separate account which is converted all by itself!

However, the greatest complication is not merely the application of the IRA aggregation rule. It is the risk that the IRS will apply the step transaction doctrine, invalidating the strategy entirely.  See part II.


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