This article, the third of a three-part series on how to implement an effective backdoor Roth strategy, was written by guest contributors Steven Jarvis, CPA, MBA, and Matthew Jarvis, CFP.
Once tax-free basis is introduced to any of a taxpayer’s IRA accounts, all distributions will be characterized on a pro rata basis until such time that the Dec. 31 balance has zero taxable dollars. One method to accomplish a $0 balance would be for the taxpayer to withdraw and/or convert 100% of their IRA balances. Depending on the taxpayer’s situation, this could make sense.
For example, when Bob (from our earlier examples) retires, his advisor may decide to convert all $106,500 of IRAs (consisting of $100,000 taxable and $6,500 tax-free basis) into a Roth and eliminate the pro rata issue altogether. (To mitigate a higher tax hit all in one year, this might be done over a few years instead of all at once.)
Alternatively, if instead of $100,000, Bob had $2 million of pretax dollars in his IRA, converting everything to Roth accounts might be foolish because of the tax bill that would be immediately due on that large of a conversion. Whatever the dollar amount, the only other option for the taxpayer to remove all taxable dollars from the IRA would be to become a participant in a company retirement plan, solo 401(k) plan, or Simple 401(k) plan (but not a Simple or SEP IRA, as they are lumped in with traditional IRAs for the pro rata rule) that accepts IRA rollovers of pretax dollars. The taxpayer could then roll the pretax funds into their company plan, leaving behind only the aftertax funds, which could then be converted into a Roth account, and giving them an IRA balance of $0.
Assuming the advisor ensured the client met all the other rules (including the SEC’s suitability requirements for registered broker/dealers and its fiduciary requirements for RIAs) of moving money in and out of a company retirement plan, and the timing of transfers was right, and their accounting was right, and they didn’t get caught by the market moving in the wrong direction midtransfer, this can and does totally work! But tread carefully.
Why Don’t the Custodians Help With This?
When faced with all the complexities around reporting IRA basis, advisors often ask why the custodians (for example, Schwab, LPL, Altruist, and so on) don’t track IRA basis like they do investment basis and, instead, simply check the box on Form 1099R to indicate “taxable amount not determined.”
As often as we curse the custodians for issuing yet another amended 1099, there is really no way they could effectively track IRA basis, as when a taxpayer makes an IRA contribution, there is no mechanism in place for them to communicate the tax deductibility status of that contribution to the account custodian. Which means that the custodian would be required to collect and analyze every accountholder’s tax return if the onus were on them to determine whether contributions were deductible or not. Thus, it is on the taxpayer, usually with the assistance of a financial advisor and tax preparer, to coordinate tracking of IRA basis.
This often leaves the advisor earning their fees by making sure this is all tracked and reported correctly.
Why Don’t Tax Preparers Like Roth Accounts, Let Alone Backdoor Roth Contributions?
As noted earlier, many tax preparers often view backdoor Roth conversions as having zero current-year tax benefit that also comes with the burden of an extra form (that is, Form 8606) that they have to complete (and sometimes even two if their clients are married). On top of that, they know that they will have to complete these forms every year for eternity.
As retired U.S. Navy SEAL Jocko Willink might say, “Tax preparer doesn’t like your strategy? GOOD! Now you can get more practice getting people to take action on your recommendations!”
For financial advisors who are considering this strategy for their clients, we would recommend they start by contacting their clients’ tax preparer, sending them a copy of this article and the simple request: “I read this article, and it looked like it might make sense for our mutual client, Bob and Sue. Could I pay for an hour of your time to get your thoughts on this strategy in general and on our process for implementing it with clients?”
Please note this is not an attempt to generate billable hours for my fellow tax professionals. Rather, it is my attempt to help advisors understand that these strategies do cost tax preparers time, as backdoor Roth conversions don’t just involve an extra form (or two for a married couple) that needs to be completed, they also require the tax preparer to answer additional questions from the taxpayer and to track down their Dec. 31 IRA balances for the pro rata calculation using the IRA aggregation rule to determine exactly how much of the conversion was or wasn’t taxable, which often involves sifting through past account statements, as these balances are not reported anywhere else on the tax return.
And by respecting the CPA’s time, advisors can catapult themselves to the top of the industry in the minds of the tax professionals they reach out to (and it could even open the door for a lucrative stream of referrals)!
Anything Else I Should Know About Backdoor Roth Conversions?
Anytime we are talking about IRAs, Roths, contributions, and conversions, we need to revisit both the five-year rule that applies to Roth conversions (which serves to determine whether the principal of amounts converted to Roth can be considered penalty-free) and the five-year rule that applies to Roth contributions (which serves to determine whether a withdrawal of growth from a Roth IRA would be considered a tax-free “qualified” distribution, and for which separate rules exist for Roth accounts under employer retirement plans).
Our go-to reference is this past blog article about Understanding the Two 5-Year Rules for Roth IRA Contributions and Conversions, but here is a quick refresher, courtesy of Micah Shilanski:
Any distributions taken from a qualified account are characterized in the following order: first from contributions, then from conversions, and lastly from growth.
The first Five-Year Rule (for Roth conversion principal) says that account owners under age 59½ must wait five years before they can withdraw the principal of a prior Roth conversion without penalty (ignoring any other qualifying event). Once the client reaches age 59½, this five-year rule is no longer an issue.
The second Five-Year Rule (for Roth growth of any type) says that any growth on a Roth (from contributions or converted amounts) cannot be withdrawn without penalty until account owners have had any Roth account open for at least five years (and they must be over age 59½, or deceased or disabled, or using the money under the first-time homebuyer exception).
Example: Jane and Jim’s financial advisor has determined that they are good candidates for using the backdoor Roth strategy.
Jane is 50 years old and never before has she opened an IRA account. Jim is 57 years old and has had a Roth IRA open for 15 years.
Their advisor establishes new traditional IRA accounts for each of them and a new Roth IRA account for Jane (as Jim already has one). After having each of them deposit $6,500 into their new traditional IRA accounts, the advisor successfully facilitates backdoor Roth conversions of $6,500 for each of them.
The prior contributions that Jim has put into his Roth IRA can be withdrawn at any time free of taxes or penalties, but the new Roth conversions they put into their respective Roth accounts this year cannot be withdrawn for five years (in the case of Jane) or for 2.5 years in the case of Jim (as once he reaches 59½, there is no early withdrawal penalty and the rest of that five-year rule is moot).
When it comes to the growth of the accounts, Jane will be obligated to wait until she reaches age 59½ to access those amounts tax-free (as that is the later of five years and age 59½). In Jim’s case, because he has already had a Roth IRA in place for more than five years (already satisfying that rule), he will be able to access the growth tax-free in 2.5 years when he reaches age 59½.
In the event that Jane or Jim becomes disabled or dies, the growth in Jim’s Roth would immediately be tax-free (since his five-year rule was already satisfied) but Jane (or her beneficiaries) would have to wait out the remainder of the five-year rule to access the growth tax-free.
So, Now What? A 5-Step Checklist
While there are many potential pitfalls, this five-step checklist, which ideally would be built into an advisor’s CRM system, will greatly enhance the advisor’s ability to implement this strategy successfully and efficiently.
1. Is a Backdoor Roth Contribution Right for the Client?
Does the client have sufficient earned income to cover the IRA contribution (and too much to disqualify them from making a Roth IRA contribution directly)? Have all IRA balances (including those in Simple and SEP accounts) been accounted for? Has the timing of any potential rollovers and prior IRA basis been considered? If the client does not have a “clean” situation, is there a strategy in place for separating the proverbial tax-free cream from the tax-deferred coffee in the future?
If yes to all of these, a backdoor Roth conversion can be a practical and beneficial strategy to recommend to the client.
2. Was the Traditional IRA Contribution(s) Done Correctly?
Was a traditional IRA contribution made in the current or prior year? Can the client make a catch-up contribution? Where are the funds coming from? Was the tax preparer consulted/advised, and do they know to report this as nondeductible?
For a conventional backdoor Roth contribution, this step includes verifying that the funds were contributed to a qualified account and that no deduction was reported on the client’s 1040 for the year (if a deduction was taken, it would appear on line 10 of the 1040 and schedule 1).
3. Was the Conversion Distribution From the Traditional IRA Reported Correctly?
While custodians typically do the distribution and conversion on a single form, it is reported to the IRS as a distribution from the IRA and a conversion/contribution into the Roth. The form 1099-R that is issued for the distribution will inevitably be marked as “taxable amount not determined” and will likely include the full amount as a “taxable distribution” on the form. Communication is key to ensure this is correctly reported on Form 1040 in spite of the 1099-R being potentially misleading.
While frustrating that the reporting is not more clear, this is the reality of how the system currently works. There is no need to contact the custodian or try to amend or adjust the 1099-R. The “taxable amount not determined” box tells the IRS that there is more to consider, so as long as Form 1040 is correct, the seeming contradiction between the tax return and 1099-R will not create an issue.
4. Was the Transfer to the Roth Account Reported as a Roth Conversion?
This move will need to be reflected on both IRS Form 1040 and Form 8606 (see examples included in this article). The tax-free benefits are not fully recognized until the conversion is completed and the funds are moved into a Roth account.
While contributions are reported in Part 1 of Form 8606, conversions are reported in Part 2 and are commonly left out by tax preparers. While not completing Part 2 of Form 8606 likely will not affect how much tax is paid in the year of the conversion, the form serves as a useful paper trail if questions come up in the future about conversions and contributions made into a taxpayer’s Roth account (especially if the client needs to take out Roth conversion principal before age 59½ and then has to document that the five-year rule on Roth conversion principal has been satisfied).
5. Was the Tax Return Filed Correctly?
This often requires reminding the client and tax preparer in January and then personally reviewing the return, including Form 8606, for accuracy once filed. Every planning recommendation that involves money has a tax impact of some kind. One of the best ways an advisor can impact a client having a successful tax return filed is to prepare an annual letter summarizing the tax impacts of the work they helped their client with during the year.
For this to be effective, there needs to be a system for accurately preparing the letter and communicating the results of the year to the client in a way that they can easily share it with their tax professional. Until a tax-planning strategy has been reported to the IRS correctly, it is not complete.
If this all sounds complicated and labor-intensive, take a step back to remind yourself that strategies like these can be beneficial and well worth the effort they require to implement; taking the time to understand them and making the effort to explain how and why things work to clients (and their tax preparers) is exactly what differentiates a Financial Advicer from a financial advisor.
It’s also what sets advicers apart from all of the firms that won’t touch anything tax-related and gives them an advantage when attempting to demonstrate to prospective clients why their firm is the best fit for their needs.
Steven Jarvis, CPA, MBA, is the CEO and head CPA at Retirement Tax Services, a tax firm focused on working with financial advisors to change the world one tax return at a time.
Matthew Jarvis, CFP, is the owner and lead advisor of Jarvis Financial Services.
This article first appeared on the Nerd’s Eye View at Kitces.com and has been reprinted here with permission. The views expressed here are the authors’.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.