Backdoor Roth IRAs For the Highly Compensated

Take-Away: For individuals who want to fund a Roth IRA, but whose modified adjusted gross income (MAGI) is too high to permit funding a Roth IRA, the backdoor Roth IRA strategy can be used with an after-tax traditional IRA contribution. Backdoor Roth IRAs were of questionable legality until the 2017 Tax Act, which appears to have formally legitimized them.

Background: A backdoor Roth IRA is a strategy used to avoid the modified adjusted gross income (MAGI) limitation on an individual’s ability to fund a Roth IRA.

• Legality: The strategy was acknowledged along with the 2017 Tax Act. The Congressional Conference Report associated with the 2017 Tax Act noted: “Although an individual with AGI exceeding certain limits is not permitted to make a contribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA.”
• Conditions: To contribute to a Roth IRA an individual and/or his/her spouse must have earned income. They can make Roth IRA contributions for themselves or their spouse who is not working as long as they file a joint income tax return. Age is not a problem as long as the Roth IRA owner is under age 70 ½, is still working, and earning income.
• Contributions: Roth IRA contributions are limited to $6,000 a year, or $7,000 a year if the individual is over age 50 years.
• MAGI Limitation: The primary limitation to funding a Roth IRA is the amount of modified adjusted gross income (MAGI) that is reported, which can prohibit a Roth IRA contribution. For 2019, the MAGI limit for a married individual who files jointly with their spouse starts at $193,000, and is fully phased in (i.e. no contribution is permitted) at $203,000. For an individual, his/her MAGI limit starts at $122,000 and is fully phased in (i.e. no contribution is permitted) at $137,000. Consequently, with reported MAGI above those dollar limits, no Roth IRA contribution is allowed.
• Contribution v Conversion: The MAGI limitations are designed to prevent Roth IRA contributions for a year. The MAGI limitations do not, however, apply if a traditional IRA is converted to a Roth IRA. Roth conversions can take place at any time; there is no maximum income limitation that can reduce or eliminate an individual’s ability to convert a traditional IRA to a Roth IRA.

Backdoor Roth IRA. In its simplest form, a backdoor Roth IRA is a two-step process. First, the individual makes an after-tax contribution to a traditional IRA. Second, shortly after the funding, that traditional IRA is then converted (using its after-tax dollars) to a Roth IRA. Accordingly,  in order for a backdoor Roth IRA to be a viable strategy: (i) the individual (or spouse) must have earned income; and (ii) must not have reached age 70 ½- unless the SECURE Act passes, which would extend the age at which it is permitted to make IRA contributions, beyond age 70, i.e. in order to be able to make an IRA contribution.

• Qualified Plan Limitation?: Because the backdoor Roth IRA starts with a traditional IRA contribution, the participation in a qualified plan could act as a limitation. An individual can participate in an employer-sponsored qualified plan and also fund a traditional IRA, but there are limits to how much can be deducted by the participant who contributes to a traditional IRA. These income limits phase-out the deduction to a traditional IRA are: married/filing jointly, the range is $103,000 to $123,000; single or head of household, $64,000 to $74,000.
• Backdoor Example: Betsy, a single individual, age 45, wants to make a Roth IRA contribution. Betsy has MAGI of $225,000 for the year. Betsy also participates in her employer’s 401(k) plan. Betsy is phased-out of taking an income tax deduction for her contribution to a traditional IRA due to her reported MAGI. Yet Betsy can make an after-tax contribution (with no income tax deduction) of $6,000 to her traditional IRA. 45 days later Betsy’s traditional IRA now has a balance of $6,050. Betsy converts her traditional IRA to a Roth IRA. $6,000 of the converted $6,050 will be tax-free (that amount was Betsy’s after-tax contribution.) The remaining $50.00 will be taxable upon Betsy’s backdoor Roth IRA Going forward, the entire $6,050 will be tax-free as a Roth IRA.

Traps: There are a couple of possible traps to keep in mind if a backdoor Roth IRA strategy is to be considered.

• Pro-Rata Rule: We have covered this rule in prior missives. The pro-rata rule covers the taxation of an IRA distribution or conversion when the IRA contains after-tax amounts. An IRA distribution or conversion will consist of the same proportion of pre-tax and post-tax amounts as the IRA owner owns in all of his/her combined IRAs. Reference to all IRAs includes traditional IRAs, SEP and SIMPLE IRAs. In short, all IRAs are lumped together and treated as one, big, IRA, even when the distribution or conversion is with regard to one IRA.
• Pro-Rata Example: Using Betsy’s situation above, the only change in facts is that Betsy also owns a traditional IRA with a balance of $54,000, all of which is pre-tax dollars. Consequently, when Betsy converts her new after-tax IRA containing $6,000 to a Roth IRA, she will be treated as owning one aggregate IRA worth$60,000, consisting of $6,000 after-tax contributions and $54,000 pre-tax contributions. Thus, when Betsy converts her $6,000 traditional IRA to a Roth IRA, she will owe an income tax on 90% of that conversion, or $5,400. Note: if the qualified plan in which Betsy participates permits roll-up or reverse rollover contributions of traditional IRAs into the qualified plan, Betsy could first roll-up the $54,000 in her traditional IRA to her qualified plan account, and then make the after-tax IRA contribution, followed by the backdoor Roth IRC conversion, to effectively circumvent application of the pro-rata
• Timing #1: Unlike ‘late’ contributions to an IRA, which can be made before April 15 of the following calendar year, the funds with the backdoor Roth IRA conversion must be out of the traditional IRA by December 31 in order to be treated as a conversion for that calendar year. Restated, there is no such thing as a ‘prior year Roth conversion.’
• Timing #2: If a backdoor Roth IRA conversion is pursued, it is wise that the initial IRA contribution be allowed to sit for 30 to 45 days  in the traditional IRA prior to its conversion to the Roth IRA. While there is no rule that prohibits an immediate conversion to the backdoor Roth IRA, waiting a short period with the funds in the traditional IRA will permit the contribution to be documented in the IRA custodian’s records, which is important when building the ‘paper-trail’ to document the Roth IRA conversion and to clearly identify the amount that will be taxable ( the IRA earnings during that 30 to 45 day waiting period) when the funds are finally converted to the backdoor Roth IRA.
• Post-Conversion Withdrawals: While the 10% penalty imposed for early IRA withdrawals in not applicable with any Roth IRA conversion, that penalty can still be assessed if the converted amounts are distributed to the Roth owner within five years of the conversion date when the Roth owner is under age 59 ½ at the time of the withdrawal. In contrast, if the funds are directly contributed by the individual to the Roth IRA (i.e. they are in the Roth IRA as a result of a contribution, not a conversion) those Roth funds are immediately accessible income tax-free and penalty-free.

Conclusion: In the past, there was some mild concern about pursuing a backdoor Roth IRA conversion if the IRS decided to apply its step-transaction doctrine to the strategy. Now, with Congress’ apparent blessing, anyone, despite their MAGI for the year, can engage in the backdoor Roth IRA strategy if they want a Roth IRA. Just keep in mind the pro-rata distribution rule if the goal is to avoid paying income taxes on the backdoor conversion and also remember that the 10% penalty applies if the Roth owner is under age 59 ½ and wants to take a distribution from the converted backdoor Roth IRA.