'Backdoor' Roth IRA May Be Closing for Investors

Note: This video is part of Morningstar's February 2016 Tax Relief Week special report.

Michael Kitces is a partner and the director of research for Pinnacle Advisory Group, and publisher of the financial planning industry blog Nerd's Eye View. You can follow him on Twitter at @MichaelKitces or connect with him on Google+.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

Many affluent investors have jumped at the chance to get into a "backdoor" Roth IRA. Joining me to discuss what you need to know before you do is financial planning expert Michael Kitces.

Michael, thank you for being here.

Michael Kitces: Thanks for having me.

Benz: It's IRA contribution season as we approach April 18, the deadline for making 2015 contributions. One hot topic among our Morningstar.com readers and viewers is this idea of the "backdoor Roth IRA" contribution. Let's discuss how that works.

Kitces: The basic idea of this is pretty straightforward. We're going to make a contribution to a traditional IRA and then we are going to do a conversion from an IRA to a Roth, and get money into a Roth.

The primary scenario where this matters is folks whose income is too high to make a Roth contribution in the first place. Obviously, if we were allowed to just contribute to a Roth, we would just put the money into the Roth, and that would be that. But once you get above income thresholds, you can no longer do new dollar contributions to a Roth, and this workaround strategy emerged. While at higher income levels you can't contribute to a Roth, you can always contribute a traditional IRA. There are actually no upper income limits. You may lose the deduction for your IRA contribution, but you can always contribute to it. And since 2010, there are no income limits for doing a Roth conversion--moving the money from a [traditional] IRA to a Roth. So, we get these scenarios for higher-income folks where we can't put money into the Roth, but we can put the money into a traditional IRA and then covert it into the Roth in a two-step process, and that's why it gets called a "backdoor Roth" contribution strategy. We are not going to make a Roth contribution; we're going to make a traditional contribution and convert it, and end up with a Roth contribution.

Benz: One stumbling block for this backdoor Roth IRA maneuver is that if a person has a lot of traditional IRA assets elsewhere in their portfolio, they can inadvertently run into a bigger tax bill than would otherwise be the case.

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Kitces: Yes, unfortunately. There is a rule in the world of IRAs called the Aggregation Rule. What it says is that anytime you take money out of an IRA, whether you are taking it out to spend or you are taking it out to convert it to a Roth, you have to calculate the tax consequences based on the aggregation of all of your IRAs. What that means from practical perspective, let's say I've got two accounts. I've got a $100,000 IRA that's got some old 401(k) money that rolled over in the past, and then I want to do this backdoor Roth contribution. So, I make a new $5,000 or $5,500 contribution to a traditional IRA, a stand-alone account, and then I convert that brand new $5,500 account over to a Roth.

As far as the tax code is concerned, even if these were two separate accounts, you can't just contribute $5,500 to an account and convert that account. When you convert that account, it's deemed a $5,500 conversion of the aggregate of all of your accounts. The problem is, when we aggregate all your accounts together, you had a $5,500 account over here, but a $100,000 pre-tax account over here. It gets aggregated together. Now when you convert the account, since about 96% of your account balances at that point would be pre-tax, 96% of your conversion is pre-tax, which means you get a big tax bill on your Roth conversion, and we're not really getting the full leverage of the backdoor strategy. This becomes a problem anytime we've got multiple IRA retirement accounts.

Now, the Aggregation Rule only applies to IRAs, not other employer retirement plans; your 401(k)s and profit sharing plans don't count. Your spouse's IRAs don't count. Any inherited IRAs don't count. But good, old traditional IRAs--whether the ones you contributed to or ones you've rolled money into--are all part of this Aggregation Rule, and it creates a challenge. It means we can't just make a non-deductible IRA contribution and convert it over and make a tax wash because our pre-tax IRAs get scooped into the process unless we've got them in 401(k) plans. In some cases, we even see investors roll the pre-tax money from an IRA out to a 401(k) plan, if they've got a 401(k) that will let you roll money in, just to clear the decks.

Benz: That can be a workaround for people who do have that 401(k) plan, but it must allow those roll-ins…

Kitces: If you've got a 401(k) plan that allows a roll-in, which not all do.

Benz: A couple of questions have been weighing on backdoor Roth IRA contributors' minds. One is how long to wait? So, I make that contribution to the traditional IRA, and then I've got to convert it to a Roth at some point. People have probably heard, don't wait too long, because if you start building up investment gains, those will be taxable. But what is the right amount of time to wait between these two transactions?

Kitces: The short answer is, we don't definitively know how long you have to wait. There is a long-standing IRS and tax court rule called the "Step Transaction Doctrine," and this is basically a rule that says, if you do a transaction in multiple steps, each one of which would be legal but the aggregate of which would not, the IRS and tax court are allowed to come in and say, look, if it walks like a duck and it quacks like a duck, we're going to tax it like a duck. We're going to call the transaction what it was in the aggregate even though the individual steps were individually permissible. Unfortunately, the backdoor Roth contribution is a classic example of this. We even call it that. We call it "backdoor Roth contribution" to make the point that we're doing a Roth contribution that you weren't supposed to be allowed to do.

Now, the way you get around this rule of having all your transactions consolidated together and then punished for what basically would be an excess Roth contribution, contributing when you weren't allowed to because of your income... The way you get around this is you to allow time to pass between the contribution and the subsequent conversion. So, if you ever, for some reason, ended up in front of the IRS or a tax court judge, you could in good faith say, "No, your honor. These were two completely independent transactions. It wasn't part of a single step deal. I made a stand-alone IRA contribution, which I'm allowed to do. I made an unrelated Roth conversion. You have to treat these separately. Each one was permissible. Therefore, I shouldn't get in trouble, and I should be allowed to do this."

The tax court historically has not actually given a lot of guidance on how long you are supposed to wait for this. They call it a facts-and-circumstances test, which means they just look at the actual facts and circumstances to try to understand what your intent was and whether your intent was to break the rules and do something backdoor you weren't supposed to, or whether you were really doing independent transactions.

When we look at some other scenarios where the IRS has challenged these sorts of transactions-- there was a strategy many years ago with annuity exchanges that was similar, where you would partially exchange money from one annuity to a new one, and then liquidate from the new annuity, and you got better tax consequences than taking it from the original annuity. When the IRS cracked down on this after several years of abuse, they said, if you wait a year, a full 12 months, between when you do the annuity exchange and the subsequent withdrawal, we'll assume that's enough time in between that it won't be abusive, and we are not going to come after you for it.

So, that's what we've been using as a guideline, as a rule of thumb with clients: If you want to do this, put the dollars in now, wait 12 months, and 12 months from now you can do your Roth conversion as a separate transaction. Once you have done that, a couple of weeks or months later you might then do a new Roth contribution to repeat the process the following year so we can move along over time. Basically, let the dollars season in the IRA for a year just so that if the IRS ever does come and ask the question, "Why shouldn't we just tax this as an excess Roth contribution?" You can say in good faith, "I made a stand-alone IRA contribution. I let it invest for a while, and I just decided of my own free will a year later in a separate decision to do a Roth conversion, and I shouldn't be punished for that."

Benz: Given that period of time you recommend that your clients wait, do you recommend that they hold the money in a cash-like vehicle to avoid having any gains build up in that account?

Kitces: No, we actually recommend that it gets invested. The only person that puts money into their IRA and lets it sit in cash for the long run and then converts it to a Roth is a person who is trying to cheat the Roth contribution rules. To me, if the IRS comes and questions you about this, you are actually making their case for them by leaving the money in cash throughout and then magically investing it into stocks the day after you move into the Roth. You are actually cementing the point for them that you were really just trying to defeat the Roth contribution rules in an improper manner rather than doing two discrete separate transactions. So, we encourage people to go ahead and actually invest the money.

The worst-case scenario is, it goes up. When you do the subsequent conversion, you will have to pay a little bit of taxes on your gain, which is just a nice way of saying, bad news, you made money, you pay a little bit of taxes. You are still ahead. Recognize that. If my choice is, put in $5,500, have it go up and pay a little in taxes, or put in $5,500, miss all the upside and leave it in cash and have no taxes and also no gains. You've still lost. Taxes don't take all the money. It only takes a portion of the money.

So frankly, for both investment purposes and to validate the transaction, we encourage people to go ahead and invest it. Worst case, there will be a little bit of a tax bite only because you made money, not the worst problem in the world. And if you're ultimately going to have the money in the Roth for 20, 30, 40, or 50 years, and you want to make sure that that is validated and not challenged by the IRS, having a little bit of gain in one year is not going to blow up the long-term value of the strategy.

Benz: That's a good set of logistical points. But let's talk about another thing that has been weighing on many backdoor Roth IRA contributors' minds--the idea that Congress at some point is going to look at this loophole and say, we've got a bunch of higher-income folks whom we didn't intend to have Roth IRAs opening these accounts. Is there a risk that this loophole will be closed?

Kitces: I think the odds that the loophole gets closed are very high. In fact, it's already on the radar screen of Washington, D.C. When we look back at President Obama's budget last year in 2015, his budget proposals even then included a proposed rule that said no Roth conversions of any kind of aftertax dollars. That would eliminate the backdoor Roth contribution. That would also eliminate some of the strategies where you have aftertax money in a 401(k) and do that conversion, which some people even call a super-charged backdoor Roth. It would shut all those down by simply saying, if you've got aftertax dollars in your IRA, that's fine, bully for you. But those dollars can't be converted. Only your pre-tax dollars can be converted and generate the normal tax bill on a conversion. So, it's already on the IRS' radar screens; it's already on Congress' radar screen. [Note: President Obama's budget proposal for fiscal-year 2017, released after this video was taped, also included a provision that would clamp down on the backdoor Roth IRA. This article discusses this and other retirement-related provisions in the Obama budget.]

Now, we'll see how quickly it really gets done to shut this down. The reality in recent years is Congress hasn't really been getting a lot of tax legislation done. We've had almost nothing for seven years now in terms of major tax legislation besides those year-end tax extenders, which usually only get done because we don't do anything else but just extend, or extend and make permanent. So, it takes a little while, given how the sausage gets made in Washington. It takes a little while for legislation to get done, but the odds are looking more and more likely that it will happen.

The good news--at least for people that have been doing this over time: It almost certainly won't go retroactive if only because it's very hard for the IRS to even track these down retroactively. We've heard from a couple of people now who just on random audit had an IRS agent come in, saw it, caught it, said, that's not appropriate, and the people actually had unwound it in part because it was easier to unwind it than to fight the IRS, which is expensive compared to a $5,500 IRA contribution.

So, a crackdown on this probably won't go retroactive. It would probably just say, going forward, no more new Roth conversions of aftertax dollars as of this date, maybe starting next calendar year or something to that effect.

But I think it's only a matter of time before it happens. Unfortunately, the strategy has gotten out there. It's now on the radar screen in Washington. Congress has been very clear that it is not something that they intended to happen. If they wanted this to happen, they would have just repealed the Roth contribution limits in the first place. So, the fact that the contribution limits are there is the unequivocal statement from Congress: "we did not intend this to happen." It was an unintended consequence of eliminating the Roth conversion limits back in 2010. It takes a couple of years for Congress to sometimes crack down on the loopholes once they create them, but it's probably only a matter of time before it goes away.

Benz: It's been a very popular maneuver as long as it's been going.

Kitces: However long it lasts.

Benz: Right. Thank you for being here to share your insights.

Kitces: My pleasure.

Michael Kitces is a partner and the director of research for Pinnacle Advisory Group, and publisher of the financial planning industry blog Nerd's Eye View. You can follow him on Twitter at @MichaelKitces or connect with him on Google+.