The tax filing deadline is rapidly approaching, and this year may be the final year that taxpayers can take advantage of a controversial loophole in the tax code: the Backdoor Roth IRA. Before the window of opportunity closes, it’s worth learning about what this loophole means and if you can take advantage of it.
The Benefits of Roth
First off, it’s important to understand the benefits of contributing to a Roth IRA. Contributors must pay income tax on Roth IRA contributions up-front. However, unlike a traditional IRA, Roth IRAs allow savers to withdraw both principal and investment earnings tax-free after retirement.
In other words, once contributors pay taxes on Roth IRA contributions up-front, they are finished paying taxes regardless of how much investment returns they earn over time.
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The only potential caveat to the Roth IRA is that high-income earners cannot make Roth IRA contributions. The current income cut-off point for individuals is $131,000 and for married couples filing jointly it’s $193,000. So if you’re earning income below these levels, you won’t miss anything if the Backdoor Roth IRA conversion loophole is closed.
The basic idea behind the conversion loophole is, as of 2010, anyone at any income level is allowed to convert traditional IRAs into Roth IRAs. That means that those earning income above the cut-off point for Roth IRA contributions can simply contribute to a traditional IRA and then later convert those contributions legally into a Roth IRA.
In a nutshell, the law places income limits on Roth IRA contributions but not on Roth IRA conversions.
Here’s the true beauty of the Backdoor Roth IRA. If the traditional IRA contribution of up to $5,500 per year is deductible, the whole process ultimately doesn’t cost high-income earners a single cent.
They end up with an IRA deduction of $5,500 on Line 32 of Form 1040, Roth conversion income of $5,500 on Line 15 of Form 1040 and a net gross income adjustment of $0 with a $0 tax liability!
Dangers of the Backdoor Roth IRA
As of 2016, making Backdoor Roth IRA contributions in this way is completely legal, as long as it is done correctly. There are two major stumbling blocks when it comes to this process. The first stumbling block is the IRA aggregation rule.
The IRA aggregation rule stipulates that all separate traditional IRA accounts be treated as a single account when determining the tax consequences of a Roth conversion. This rule can complicate things for taxpayers who have existing IRA accounts and have made nondeductible contributions to these accounts.
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In essence, any new $5,500 IRA contribution, even if completely deductible and made to a brand new account, would be pooled with existing IRA accounts prior to a potential conversion. Therefore, any IRA funds that are subsequently converted to a Roth account, even the deductible $5,500 added to the new account, would be subject to ordinary income tax based on the percentage of the total IRA pool that is nondeductible.
The other major stumbling block when it comes to the Backdoor Roth IRA contribution is a rule called the step transaction doctrine. In essence, if the steps involved in a Backdoor Roth IRA conversion are done in rapid succession, the IRS could deem them a single transaction and rule that the contribution is an impermissible Roth contribution subject to an excess contribution penalty of 6%.
Although there is no clearly-defined rule about how much time must pass between the original IRA contribution and the conversion, the general rule of thumb is that one year is enough time for the IRS to conclude that the two steps were separate transactions.
President Obama has fought hard to close the Backdoor Roth IRA conversion loophole, so this year could be the last year to take advantage of the opportunity. If done correctly, this conversion provides a legal tax-free workaround for high-income earners that still want to enjoy the benefits of a Roth IRA.