Some taxpayers can’t make a nondeductible contribution to a Roth IRA if their income exceeds the annually adjusted threshold limits. For 2019, the threshold levels are $203,000 for married filing jointly, $10,000 (yes, $10,000—that isn’t a typo) for married filing separately, and $137,000 for all other taxpayers. A taxpayer with earned income (regardless of the amount), though, can make a nondeductible contribution to an IRA if he or she isn’t yet 70-and-a-half years old. Once Congress removed the $100,000 adjusted gross income (AGI) limit on converting IRA funds to a Roth IRA in 2010, the stage was set for the introduction of the backdoor Roth IRA.
A backdoor Roth IRA transaction begins with a taxpayer making a nondeductible contribution to a newly created traditional IRA. Next, the funds are transferred to a Roth IRA. On the surface, the transaction is simple. So what are the real and possible hazards that a person should keep in mind?
In a typical situation, the taxpayer already has an existing IRA with previously deducted or nondeducted contributions and untaxed earnings. In this case, the taxpayer makes a nondeductible contribution to his or her IRA and then converts some of the amount into his or her Roth IRA. But the conversion requires the taxpayer to determine the taxable and nontaxable portion of the converted amount pursuant to the IRC §72 rules. Although the rules aren’t difficult, the conversion will be partly taxable, which defeats the objective of contributing to a Roth IRA. And it doesn’t matter if the taxpayer has one or more traditional IRAs, a Simplified Employee Pension (SEP), or a Savings Incentive Match Plan for Employees IRA (SIMPLE IRA)—they’re all treated as a single IRA for this transaction.
AVOIDING THE PROBLEM
One way to circumvent this dilemma is to transfer (i.e., through a direct rollover) all the pretax IRA holdings into the taxpayer’s employer’s qualified plan, e.g., a 401(k), 403(b), or 457 plan. If the employer’s plan allows the transfer, the rollover is nontaxable. Alternatively, the taxpayer might convert all the IRA holdings into his or her Roth IRA and include the pretax amount in gross income. This transaction is partially taxable and may not be appealing to the taxpayer. Once the IRA is (or IRAs are) zeroed out, then it might be time to consider the backdoor Roth IRA.
In the case of a couple filing jointly, a backdoor Roth IRA may be completed for the spouse who doesn’t have any existing IRAs.
Although the Internal Revenue Service (IRS) hasn’t challenged backdoor Roth IRA transactions in the past, keep in mind that it could apply the economic substance doctrine (form over substance argument) or the two-step transaction doctrine on the transaction. But, again, the IRS hasn’t challenged these transactions yet. Maybe it’s expecting Congress to remove the threshold rules for making Roth IRA contributions.
Yet Congress has indirectly given its blessing to the backdoor Roth IRA transactions. Footnotes 268 and 269 of the Joint Explanatory Statement of the Committee of Conference from 2017 state, “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.” It makes one wonder why Congress didn’t simply remove the income limits for Roth contributions instead of setting up this convoluted transaction.
A conversion could affect taxpayers planning to apply for Medicare Part B. The standard monthly premiums may be increased based on the taxpayer’s reported income to the IRS from two years earlier, which is the most recent tax return information provided to Social Security by the IRS. That is, the monthly cost of Medicare Part B for 2021 is based on the income in 2019. Thus, doing a conversion within two years of applying for or being enrolled in Medicare Part B could easily increase the monthly cost for the taxpayer (and spouse) for that year.
Another issue often ignored is the impact of state income tax on a conversion. Except for states without an income tax or a tax on retirement income, a conversion may be fully or partially taxable at the state income tax level. While many states simply include in state gross income whatever amount is included in federal income, some states provide an exclusion amount for a distribution from a pension or an IRA if the person is over a certain age.
The age varies among states. Colorado, for example, sets its pension subtraction for taxpayers age 55 and older. Delaware residents qualify for one exclusion amount if they are under age 60 on December 31 and for a higher amount if they are 60 and older on December 31. South Carolina residents qualify if they are 65 during the year.
In addition, some states treat a conversion amount differently. Pennsylvania and Illinois exclude the entire conversion amount from tax. New Jersey and Massachusetts don’t permit a taxpayer to deduct a contribution to an IRA even if the contribution is deductible for federal income taxes. So these taxpayers must determine not only their taxable and nontaxable portions for their federal tax return but also their state tax return, which is different.
Doing a conversion in a year that a taxpayer changes his or her domicile can create yet another tax situation. For example, Oregon will require the entire taxable amount of the Roth conversion to be included in state gross income if the taxpayer is a resident of Oregon at the time of the conversion. Iowa, on the other hand, requires the taxpayer to include in state gross income the portion of the taxable amount attributable to his or her months of residency in the state. But Iowa goes one step further by stipulating that a month is determined if the taxpayer spends 16 or more days (15 days for February) in Iowa.
Another strategy to consider is to contribute annually to one’s children’s or grandchildren’s Roth IRA, assuming they have income. Since the contribution is currently limited to $6,000 per year, it’s well below the current annual gift tax exclusion amount of $15,000 per year. This assumes the children are qualified to make a Roth contribution but don’t because they’re still paying off college loans.
Overall, Roth IRAs are attractive because of the zero tax on earnings and withdrawals. But there are several things to be mindful of before encouraging a taxpayer to do a backdoor or conversion to a Roth IRA. Otherwise, the individual may encounter a federal or state income tax surprise.
© 2019 A.P. Curatola