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Retirement Perspectives

Now that tax reform has spared this workaround for high-income earners, let’s review how this popular strategy can work to their advantage.

Considering all the questions I get about backdoor Roths (and failed attempts to eliminate such retirement vehicles, here’s a refresher for retirement savers who want to contribute to a Roth IRA, but who are prohibited due to income limits.

Remember that Roth IRAs are always funded with aftertax contributions. Earnings may be withdrawn tax-free as long as a distribution is taken once the account owner reaches age 59½ and has satisfied the five-year holding period. As previously mentioned, high-income earners—that is, those whose household incomes exceed $199,000 for married couples filing jointly and $135,000 for singles—typically have not been able to take advantage of this retirement-savings strategy. (See Table 1.)

However, since 2010, taxpayers who are ineligible to make Roth IRA contributions, due to income, may still do so through the "back door" by contributing funds to a traditional IRA and subsequently converting the funds to a Roth IRA.

 

Table 1. Roth Income Limits for 2017 and 2018

Source: Internal Revenue Service
*Eligibility determined by modified adjusted gross income.

 

How It Works
The first step in establishing a Roth IRA via the “backdoor” starts when an investor funds a traditional IRA on a nondeductible (aftertax) basis. Anyone younger than 70½ and who has earned income is eligible to contribute to a traditional IRA, regardless of household income. Aftertax contributions are reported and tracked via IRS Form 8606, “Nondeductible IRAs,” which informs the IRS that your IRA was funded with aftertax dollars.

Once the traditional IRA has been funded, and as soon as the IRA custodian permits, the investor may convert the traditional IRA proceeds to a Roth IRA. This can be done in a matter of days. Given such a short holding period, there likely will be little or no appreciation in the account and, consequently, little or no tax incurred.

What’s the Catch?
The caveat is the IRS’s “pro-rata” rule that is triggered upon conversion. In a nutshell, the rule states that IRA accountholders must aggregate account values in all their traditional IRAs (including SEP and SIMPLE IRAs) when determining the taxable portion upon converting to a Roth IRA. In other words, for existing traditional IRAs, previously untaxed contributions and any earnings thereafter—including those accounts that are not converted—will be taxed as if the accountholder were taking a distribution. Therefore, the backdoor strategy tends to work best for investors who don’t already own an IRA.

Another strategy exists for those individuals that own a number of traditional IRAs. Qualified plan accounts (e.g., 401(k), 403(b), 457(b)) are not included in the pro-rata calculation, thus offering individuals the ability roll pretax traditional IRAs funds into their employer sponsored plan account.

Although the concept is rather straightforward, there are a number of variables that could determine whether a newly established Roth via the “backdoor” will be free of income taxes.  Here are some frequently asked questions:

Q. Assuming an individual has multiple IRAs that include both pretax and aftertax contributions, how are taxes calculated when traditional IRA funds are converted to a Roth IRA?
A.
Taxes are determined on a pro-rata basis.  For tax purposes, IRS rules require aggregation of all individual IRAs, effectively treating them collectively as one single IRA, regardless of whether they contain pretax or aftertax dollars. Taxpayers should report and track their aftertax contributions on IRS Form 8606, which is used to determine how much a distribution or conversion are subject income taxes. 

The pro-rata calculation is determined by taking the aggregated year account value of all individuals IRAs (excluding Roth and inherited IRAs) and dividing that figure into the total amount of all aftertax dollars.  The resulting percentage (called “basis recovery”) is then applied to the distribution to determine the tax-free portion of the withdrawal.

Here’s a hypothetical example: Sally has IRA accounts totaling $80,000 at the end of 2017, the year the conversion occurred, and her IRAs contained $10,000 of aftertax dollars. She converted $20,000. However, Sally must complete a calculation to determine basis recovery (i.e., how much of her conversion is income tax–free). The calculation would look like this:  

Sally will pay taxes on $18,000 of her $20,000 conversion, while $2,000 is recovered tax-free. The taxable amount is added to Sally’s 2017 income tax return

Q. What type(s) of IRAs are including in the pro-rata calculation?
A.
The value of all an individual’s IRAs, whether traditional, rollover, SEP, and/or SIMPLE IRAs, are included in the pro-rata formula. Notably, Roth IRA and all inherited IRAs excluded.

Q. Are both spouses’ IRAs included in the pro-rata calculation?
A.
No. Instead, the formula includes only IRAs owned by the spouse completing the transaction.

Q. Can qualified plan accounts, such as 401(k)s, play a role in the pro-rata calculation?
A.
Qualified plan assets are specifically excluded. However, an IRA rollover from an existing employer-sponsored (e.g., 401(k), 403(b), etc.) in the same calendar year could affect the amount subject to taxation.

Tip: Investors with large IRAs could potentially rollover all of their pretax dollars into their 401(k) account (assuming their current employer offers a plan and allows for rollovers), thus excluding those assets from consideration in regards to the pro-rata formula, thereby offering a tax-free Roth conversion.

Q. Can I change my mind?
A
.  No. The Tax Cuts and Jobs Act, signed by President Trump on December 22, 2017, repeals recharacterizations for Roth conversions. In other words, a Roth conversion is now irrevocable.

If you have any questions about this or another retirement topic, please e-mail me at roadtoretirement@lordabbett.com.

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

A SIMPLE IRA plan is an IRA-based plan that gives small-business employers a simplified method to make contributions toward their employees’ retirement and their own retirement. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer makes matching or nonelective contributions. All contributions are made directly to an individual retirement account (IRA) set up for each employee (a SIMPLE IRA). SIMPLE IRA plans are maintained on a calendar-year basis.

A simplified employee pension plan (SEP IRA) is a retirement plan specifically designed for self-employed people and small-business owners. When establishing a SEP-IRA plan for your business, you and any eligible employees establish your own separate SEP-IRA; employer contributions are then made into each eligible employee’s SEP IRA.

401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an aftertax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.

A 403(b) plan is a retirement savings plan that allows employees of public schools, nonprofit, and 501(c)(3) tax-exempt organizations to invest on a pretax and or Roth aftertax basis. Contributions to a 403(b) plan are conveniently deducted directly from your paycheck. In addition, your employer may elect to make a contribution on your behalf.

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