Prior to the Tax Cuts and Jobs Act (“TCJA”), it was not clear whether “back-door” Roth IRA conversions were permitted. The TCJA was signed into law on December 22, 2017.
Language in the Conference Report accompanying the bill clarifies that the back-door conversions are a known and permitted maneuver. The back-door Roth IRA conversion side-steps the income limits for performing a contribution to a Roth IRA.
For the 2018 tax year, contributions to a Roth IRA are phased out for taxpayers having a Modified Adjusted Gross Income (MAGI) between $185,000 and $199,000 for joint filers and $120,000 to $130,000 for single filers. Taxpayers with income above these amounts may not contribute to a Roth IRA. However, higher income taxpayers may still perform contributions to a traditional IRA.
The back-door conversion takes advantage of the fact that there is no income limit on converting an existing IRA to a Roth IRA. Here is how the strategy works. First, the higher-income taxpayer contributes to a traditional IRA. Then, the taxpayer converts that traditional IRA account into a Roth IRA. This effectively allows a taxpayer to contribute to a Roth IRA even though they are prohibited from contributing directly to the Roth IRA due to the income limitations.
Many taxpayers and tax preparers were concerned that the back-door strategy was vulnerable to the step-transaction doctrine wherein the IRS might seek to collapse the independently legal steps taken by the taxpayer and treat the transaction as an integrated event, in this case a direct contribution to the Roth IRA subject to the excess contribution penalty.
Deep in the text of the Conference Report to the TCJA was a statement that Congress approved back-door conversions. Footnotes 268 and 269 state:
- 268: 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, as discussed below.
- 269: 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.
- p 289: To Conference report to accompany H.R. 1, available here.
However, new rules under the TCJA now prevent taxpayers utilizing the back-door strategy from recharacterizing back door conversions to an IRA:
Under the provision, the special rule that allows a contribution to one type of IRA to be recharacterized as a contribution to the other type of IRA does not apply to a conversion contribution to a Roth IRA. Thus, recharacterization cannot be used to unwind a Roth conversion.
- p. 291: Footnote 277 explains:
- 277: In addition, an individual may still make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA, but the provision precludes the individual from later unwinding the conversion through a recharacterization.
- p. 291: Therefore, beginning in 2018 taxpayers performing a backdoor conversion can no longer reverse the transaction in the event of a market downturn or other decrease in the converted asset value to minimize tax.
Taxpayers performing the strategy should also proceed with caution regarding the application of the IRA aggregation rules.
If you have any questions about retirement planning strategies and taxation, please contact a member of the Tax, Trusts, and Estates Group.