The backdoor Roth IRA has long functioned as a workaround for higher income clients who wish to contribute to a Roth, but are technically barred by the income restrictions that apply to these accounts.

While the strategy was not uncommon, technically its legality was only recently confirmed by the Conference Committee report on the 2017 Tax Cuts and Jobs Act.  This means that clients who may have previously been on the fence about using this technique to create a tax-free income stream during retirement may now be much more interested in the strategy — especially considering the currently reduced tax rates applicable from 2018-2025.

Before a client rushes to fund a backdoor Roth IRA, however, it’s important that he or she understand that even this so-called “backdoor” strategy is subject to IRS rules and restrictions that must be followed to avoid turning a valuable retirement planning strategy into a tax setback.

The Backdoor Roth Strategy

As the name suggests, the backdoor Roth IRA strategy essentially provides an alternate route to funding a Roth IRA for clients whose income exceeds the annual limits for contributing directly to a Roth. In 2018, the ability to make contributions to a Roth IRA begins to phase out for joint filers with income over $189,000 ($120,000 for single clients). Roth contributions are completely blocked for married clients who earn over $199,000 and single clients who earn over $135,000.

Fortunately, these higher income clients are still allowed to contribute to a traditional IRA (although those contributions might not be tax-deductible because of the income limits that apply to deductible IRA contributions). To use the backdoor Roth strategy, the client simply opens and funds a traditional IRA and then converts those funds to a Roth IRA (paying income tax on the converted amounts at his or her ordinary income tax rate). The client, of course, will want to do the math to ensure that the conversion won’t push him or her into a higher tax bracket for the year.

The process can then be repeated over time in order to grow the account value (remembering that the client can convert more than the $5,500 annual IRA contribution limit each year).  However, while this strategy is available to higher income clients, it is not available to every higher income client.

Potential Traps

In order to contribute to the traditional IRA in the first place, the client must have “earned income” for the year (whether in the form of wages or self-employment income). Even if both spouses do not work, each spouse may contribute to their own account if they file a joint return and at least one of the spouses has enough earned income to justify the contribution (the annual IRA contribution limit is capped at the amount of the client’s earned income, if that is less than the annual limit).

Further, clients who have already reached age 70 ½ (so that they are required to take distributions from their traditional IRAs) are not entitled to contribute to a traditional IRA at all, meaning that the backdoor Roth strategy will not be viable.

For clients who have not yet reached age 59 ½, a five-year waiting period will apply before the client is entitled to access the funds without penalty.

Clients should also be aware of the pro-rata rule, which applies if the client does not convert all of the funds in his or her traditional, SEP and SIMPLE IRAs at one time.  Basically, the pro-rata rule requires that the proportion of pretax to after-tax contributions in the entire IRA pool be considered when determining how the backdoor Roth contribution is taxed (i.e., the client cannot choose to only convert after-tax contributions to avoid tax on the conversion if he or she is leaving pretax contributions in a traditional IRA).

Conclusion

The backdoor Roth IRA strategy can offer a powerful retirement income planning tool to high income clients — but it is important that the client understand the IRS-imposed rules and restrictions that apply to these accounts before rushing to fund a backdoor Roth.

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Robert Bloink’s insurance practice incorporates sophisticated wealth transfer techniques, as well as counseling institutions in the context of their insurance portfolios and other mortality-based exposures. Bloink, a professor at Texas A&M University School of Law, is working with William Byrnes, Associate Dean of Texas A&M University School of Law, on development of executive programs for insurance underwriters, wealth managers and financial planners. Previously, Bloink served as senior attorney in the IRS Office of Chief Counsel, Large and Mid-Sized Business Division.

Willam H. ByrnesWilliam Byrnes is the leader of National Underwriter’s Financial Advisory Publications, having been appointed in 2010. He is a professor and an associate dean of Texas A&M University School of Law. His National Underwriter publications include Tax FactsAdvanced Markets, and Sales Essentials. Byrnes held senior positions of international tax for Coopers & Lybrand and has been commissioned and consulted by a number of governments on their tax and fiscal policy.