Backdoor Roth Strategy Still an Option

Michael Kitces is a partner and the director of wealth management for Pinnacle Advisory Group, co-founder of the XY Planning Network, and publisher of the continuing education blog for financial planners, Nerd’s Eye View. You can follow him on Twitter at @MichaelKitces.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Backdoor Roth IRAs are a hot topic. Joining me via Skype to discuss them is Michael Kitces. He is a financial planning expert.

Michael, let's talk about the state of the state of backdoor Roth IRAs--what they are and whether investors can still take advantage of this maneuver.

Michael Kitces: The backdoor Roth contribution is, essentially, we've kind of come up with the workaround for the fact that Roth contributions still have income limits. If once my income is too high, I'm simply not allowed to put money into a Roth, but I'm always allowed to put money into a traditional pretax IRA regardless of income. If my income is high and I'm an active participant in an employer retirement plan, I might not get to deduct my IRA contribution, but I can always put money in as long as I have earned income to contribute.

And because we don't have income limits on Roth conversions, what that essentially means is, no income limits on the contribution, no income limits on the conversion. A contribution plus a conversion means the money ends out in your Roth account. You essentially got the money into a Roth account if you couldn't because your income was too high. We call this the backdoor Roth contribution strategy because we are kind of getting there in two steps around the back door because we couldn't just go on the front door with the contribution if we are over the income limits.

Now, a key part of that backdoor Roth is, there's a contribution and a conversion. You need to be able to do the conversion. The good news is, it means the strategy is still on the table. Because again, we didn't change anything about Roth conversions as a part of the rule changes. We can't recharacterize it. Once you do the conversion part of the backdoor Roth, make sure you are ready to stick with it. But the strategy otherwise is completely unchanged because we can still do the contributions to IRAs and we can still do the conversions. That hasn't been altered.

Benz: Were you surprised that this loophole wasn't closed? This had been on the chopping block on a couple of occasions before, but it didn't appear in the final tax law that we saw.

Kitces: Yeah. I was a little bit surprised that it didn't end out there only because there were so many other so-called loophole closures on the chopping block. This has been proposed for crackdown before. It was in the Treasury green book for several years in a row as a potential change. The change is actually very straightforward from the tax code's perspective. We would simply write a rule that says you cannot convert aftertax dollars to a Roth, and then almost all backdoor Roth and the so-called mega backdoor Roth strategy, all go away. It survived the chopping block here.

Honestly, it's still a provision that we track and expect at some point in the next few years that door will probably get closed. We will get to a point where you are just not allowed to do conversions of aftertax dollars anymore. But for the time being at least, it's still on the table, it's still valid as a strategy, and the limitation on recharacterizations really doesn't curtail it at all.

Benz: There is a major caveat, though, for this for people who are high-income and looking at this idea as a way to get some Roth IRA assets, get some assets over into the Roth column. The key thing is that you need to be careful about other traditional IRA assets that you might have in your account, right?

Kitces: Correct. There are still some tax consequences--anytime we do a Roth conversion, including money that we just contributed, got to pay taxes on the conversion amount, anything that would have been ordinary income when we withdraw it. Now, classically, one of the reasons why backdoor Roths are popular is, if your income is high and you are already active in a 401(k) plan, the money you put in your IRA is all going to be nondeductible, which means it's aftertax money anyway. If it's all after-tax money and I convert it, there is normally no tax bill because it's all aftertax money. I just put it in there. I know that.

The problem though is that anytime you do a Roth conversion, regardless of whether we are in the backdoor context or just any Roth conversion, we always have to calculate the tax consequences of a Roth conversion based on the portion of all of our IRAs in the aggregate that are taxable, not just the one account that I created. And so, the problem that crops up is, if I just put $5,000-plus into a nondeductible IRA and convert it, but off to the side I've also got this $500,000 rollover IRA from the past, as far as the IRS is concerned, you didn't covert a $5,000 after-tax account; you converted 1% of your $505,000 of which only about 1% was after-tax contributions. So, 99% of your Roth conversion is suddenly taxable, even though you only put aftertax money into that account and immediately converted it. The phenomenon of separate accounts does not exist as far as the IRS is concerned. We may do it because it's convenient to keep track of money. But for tax purposes, you only have one giant bucket and you can't only convert the after-tax portion.

It doesn't necessarily make the partial Roth conversion strategy bad. But it means you are not really doing a backdoor Roth anymore; you are just converting 1% of all your IRAs with all the tax consequences that go with it.

Benz: It sounds like checking with a tax advisor or your financial advisor to make sure that this maneuver makes sense for your probably is a good idea before you execute?

Kitces: Yeah, it's definitely important to make sure that you are looking at all the IRAs on the table when evaluating the strategy. There are some options out there of using strategies where you roll the pretax dollars out of IRAs into a 401(k) to try to segment the assets back out, so that you can convert just the after-tax IRAs that are left. But there's definitely more to it than just, I need to put money into a new IRA and immediately convert it and not pay attention to what's happening with the rest of the IRAs in the picture.

Benz: Michael, you are always such a great source of information for us. Thank you so much for being here today.

Kitces: My pleasure. Thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.