Officer
For a variety of reasons, taxpayers looking to maximize their retirement savings should consider supplementing employer- based retirement plans with individual retirement accounts (“IRAs”), and especially Roth IRAs. For high-income taxpayers, directly contributing to a Roth IRA may not be possible, but Congress permits such accounts to be funded indirectly through a maneuver commonly called the “Backdoor Roth IRA.” The rationale and mechanics behind such a strategy are discussed further.
OVERVIEW OF RETIREMENT SAVINGS OPTIONS
The critical feature of saving for retirement with employee- sponsored retirement plans and IRAs is that income that would normally be realized in a normal brokerage account is largely exempt from federal income tax. Consequently, taxpayers who are willing to wait until retirement to access their savings can benefit from the compounding of interest payments and dividends received from investments, and are free to reallocate their capital by buying and selling various securities at any point without having to pay capital gains tax. The effect of these benefits is that a retirement saving account will grow faster relative to a normal brokerage account, even if other pluses such as employer-matching contributions or estate-planning considerations are ignored.
In addition to the tax-exempt nature of retirement savings accounts, taxpayers in many cases may enjoy a tax preference applicable to contributions or withdrawals. Contributions to traditional IRAs and 401(k)s are deductible when first made; the return of contributions and investment gains are subject to tax when withdrawn at ordinary income rates. Conversely, in a Roth1 IRA and 401(k) where Roth-designated contributions are permitted, the taxpayer obtains no tax deduction when contributions are made, but later withdrawals during retirement are not subject to income tax. Roth IRAs further contain the added benefit that account holders may withdraw their contributions on a first-in-first-out basis completely tax free, even if they have not reached retirement age.
EMPLOYER-SPONSORED RETIREMENT PLAN OR IRA?
Taxpayers are generally well-served in making contributions to employer-sponsored retirement plans, as these plans will often match employee contributions and are usually available regardless of how large the employee’s salary is. But taxpayers may want retirement savings outside an employer-sponsored plan in order to get access to less conservative investment options. After all, employer-sponsored retirement plans must be managed conservatively, as the manager of the plan investments is acting as a fiduciary of the employee’s money and could incur liability if the funds are mismanaged.
In particular, in a self-directed IRA,2 the taxpayer essentially operates his or her retirement account as if it were an ordinary brokerage account. Nominally, a brokerage company is the trustee of this type of IRA, but the investment decisions are primarily made by the account holder. In a self-directed IRA, there is no requirement that the taxpayer select from a basket of funds; individual stocks or other assets of the taxpayer’s choosing may be selected. Assuming high-risk bets pay off in a self-directed Roth IRA, a taxpayer may accumulate a significant amount of wealth for retirement and not pay any income tax on the appreciation in value. In contrast, in a traditional IRA, potentially significant appreciation will eventually be taxed when withdrawn.
The combination of these two features – the ability to make aggressive bets with retirement savings and the possibility of having significant investment growth permanently escape income tax – is usually of interest to high-income taxpayers. High-income taxpayers also prefer Roth IRAs to traditional IRAs because Roth IRAs do not force required minimum distributions to be made while the IRA owner is still alive, and owners may continue to make contributions after they have reached age 70½. These two factors make Roth IRAs more valuable as part of a comprehensive estate plan compared with traditional IRAs.
The issue confronted by many high-income taxpayers, however, is that after their total gross income for a particular year exceeds a given threshold, they may no longer have access to many of the benefits IRAs offer. Taxpayers earning more than the relevant income thresholds for a given year may generally not deduct the amount of any contributions made to a traditional IRA, and they are absolutely prohibited from making contributions to Roth IRAs.
If a high-income taxpayer decides to put cash into a traditional IRA anyway, the amount is considered a “nondeductible contribution.” Regardless of whether a traditional IRA is funded in whole or in part with deductible or nondeductible contributions, earnings on investments in the account are still tax free while the funds are in the account. When distributions are made from a traditional IRA funded with nondeductible contributions, the portion of the distribution attributable to nondeductible contributions is treated as a recovery of basis and is considered tax exempt. Unlike a distribution from a Roth IRA, however, earnings on investments in a traditional IRA funded with nondeductible contributions will still be subject to tax.
THE BACKDOOR ROTH IRA, EXPLAINED
A popular planning technique continues to be the use of the so-called Backdoor Roth IRA. High-income taxpayers are prohibited from making contributions to a Roth IRA, but no such restriction prevents them from making nondeductible contributions to a traditional IRA. The Internal Revenue Code (the “Code”) also contains no restrictions that prevent a traditional IRA funded with nondeductible contributions from being converted to a Roth IRA. Effectively, a high-income taxpayer may avoid the Roth IRA income threshold by first making nondeductible contributions to a traditional IRA and then converting the account to a Roth IRA.
Normally, the conversion of a traditional IRA to a Roth IRA triggers income tax consequences, as the conversion is treated as a distribution under the Code. This type of distribution is fortunately exempted from the 10% early withdrawal tax penalty. This means the gross value of the funds coming out of the traditional IRA will be recognized as taxable income in the year the conversion occurs. As noted above, however, only amounts attributed to deductible traditional IRA contributions are taxable when withdrawn. The basis-recovery rule that applies to nondeductible contributions in a traditional IRA works to reduce the tax burden on an account holder. For example, if a traditional IRA is funded only with $5,000 of nondeductible contributions, and the account is converted to a Roth IRA at a point in the future when it has appreciated to roughly $5,100 in value, the taxpayer will recognize only $100 of taxable income on the conversion.
The reason the Backdoor Roth IRA technique works is that the rule preventing high-income individuals from taking advantage of Roth IRA conversions was taken out of the Code in 2010. Although the maneuver seems aggressive, Congress is aware that the Code currently permits such conversions to occur and has not indicated that it believes they are abusive. Specifically, Congress wrote in the Conference Report accompanying the Tax Cuts and Jobs Act, which was passed in late 2017, that it believed such conversions were permitted under existing law.
FURTHER CONSIDERATIONS
The basics of the Backdoor Roth IRA technique to fund Roth IRAs for high-income taxpayers are easy to understand, but the Code contains other potential pitfalls that need to be considered. The following items should be considered in recommending this sort of retirement planning strategy for clients:
- The Aggregation Rule. When a taxpayer converts a traditional IRA to a Roth IRA, he or she is required to aggregate all of his or her traditional IRA accounts in computing the amount of funds attributable to deductible contributions and nondeductible contributions. If a taxpayer already has significant traditional IRA assets that were funded through deductible contributions, either from a time when the taxpayer’s income was lower or perhaps were accumulated while the funds were originally in a 401(k) plan, then he or she cannot cherry-pick by claiming that only nondeductible funds are being included in the Roth IRA conversion. If the assets in a traditional IRA have already materially appreciated, the value of converting these funds to a Roth IRA may be limited. The aggregation rule does not cover contributions made to a taxpayer’s employer-sponsored retirement plans, and additionally does not force the aggregation of traditional IRAs held by separate spouses.
- Form 8606 and Dealing with Custodians. Taxpayers who make nondeductible contributions to a traditional IRA and/or convert a traditional IRA to a Roth IRA must report the transactions to the IRS and file a Form 8606 annually with their tax returns. Additionally, a taxpayer should confirm with his or her IRA custodian beforehand whether the custodian will support the transaction.
- Overall Savings Contribution Limits. It is important to remember that nondeductible contributions to a traditional IRA, as would be the case with ordinary deductible contributions, are capped annually. For taxpayers under the age of 50, the annual contribution limit is currently $6,000 per year, with an additional catch- up contribution of $1,000 per year for those who are older. Excess contributions to an IRA over this annual cap are subject to a sizable penalty if they are not withdrawn by a fixed cutoff date. The contribution limitations do not apply to rollovers and conversions.
- Five-Year Withdrawal Limit. Normally, when a distribution is made from a Roth IRA before the account holder has reached retirement age, the distribution is tax free up to the amount of the taxpayer’s original contributions. When funds are converted from a traditional IRA to a Roth IRA, the amount converted is treated as a contribution under these rules. In contrast, when a distribution is taken from a traditional IRA before the account holder has reached retirement age, the distribution is subject to tax, in addition to a 10% early withdrawal penalty. A conversion of a traditional IRA to a Roth IRA may be taxable, but it is not itself subjected to the 10% penalty. A special rule exists to prevent a taxpayer from attempting to circumvent the 10% early withdrawal penalty by converting a traditional IRA into a Roth IRA and then immediately withdrawing the funds to avoid the 10% penalty. The special rule provides that the early withdrawal penalty will still apply if any distributions from the Roth IRA receiving converted funds are made within five years of the time at which the conversion took place.
- Wage Requirement. The $6,000 annual contribution limit is actually a maximum contribution ceiling. To the extent the contributing taxpayer has earned income that is less than $6,000 per year, the annual contribution limit reflects this lower amount. Taxpayers without any wage or compensation income therefore are not able to make IRA contributions. Taxpayers may obtain some relief by filing a married-filing-joint tax return and then funding a spousal IRA. Effectively, a spousal IRA permits one working spouse to attribute his or her excess earned income to a nonworking spouse.
FINAL THOUGHTS
The Backdoor Roth IRA opens up additional tax-preferred savings opportunities for high-income taxpayers, as it essentially is an end run around the income threshold limitations. Of course, these savings opportunities assume that retirement accounts and the taxpayer’s decreased access to his or her own money while such assets are in an IRA are appropriate under the circumstances. It may be the case that the taxpayer will need funds in the near future to pay for long-term care or other family obligations, and such maneuvering could be more trouble than it is worth. The benefits should also be carefully weighed against the decision to prioritize IRA savings in lieu of any remaining employer-sponsored retirement plan contribution limits. For instance, to the extent an employee is able to obtain an employer match on additional 401(k) plan contributions, the taxpayer funding a Roth IRA with the same money that could have been put into the employer-sponsored plan is walking away from a 100% return on his or her investment.
