Roth IRA After TCJA: The Backdoor Is Still Open by Daniel Dundon

As you likely know, the Roth IRA is a terrific way to grow your wealth with a minimum tax downside because you pay the taxes up front, and then with the proper holding period, pay no taxes after that.

Eligible individuals can now contribute a total of $6,000 ($7,000 catch-up for ages 50 and up) each year to either a Roth IRA or traditional IRA.(1)

 For the Roth IRA, your ability to make contributions is phased out as your income increases.

 For 2019, this phaseout occurs when your adjusted gross income (AGI) is between $122,000 and $137,000 (single) or between $193,000 and $203,000 (married filing jointly).(2) If you earn more than the upper limits of the phaseouts, you’re completely barred from contributing to a Roth IRA.(3)

 

But that’s only if you don’t know what you are doing.

 

Front Door

 

When your income is above the phaseout, you’re not allowed to go into the Roth IRA through the front door, so to speak, and contribute directly. But there’s a back door that’s still wide open, even after tax reform. You just need to go about using it the right way.

 

The Backdoor Roth: 3 Basic Steps

 

Here are the three basic steps:(4)

  1. Create a traditional IRA, and make a “nondeductible” contribution. (If you already have a traditional IRA, the nondeductible contribution with the backdoor strategy triggers some taxable income, as you will see below.)

  2. Convert the nondeductible traditional IRA to a Roth IRA.

  3.  Pay the applicable taxes, if any, as we explain below.

Tax-Free Back Door

 

Example. You (a) are above the threshold and (b) have no existing IRAs. You make a nondeductible $6,000 contribution to a traditional IRA. Tomorrow, or shortly thereafter, you roll over the $6,000 from the nondeductible traditional IRA to the Roth IRA. You now have the Roth IRA in place via the back door, and you incurred no taxes making this backdoor move.

Taxable Back Door

Example. You own traditional IRA #1, which has a value of $12,000, funded entirely with deductible contributions. You create traditional IRA #2 and fund it with a $6,000 nondeductible contribution. You then convert IRA #2 to a Roth IRA.

 

The IRS looks at all your IRA accounts to determine whether you must pay tax on the conversion, and $12,000 of the $18,000 in your combined IRA funds consists of previously untaxed money. Thus, you will have to pay tax on two-thirds of your contribution ($12,000 ÷ $18,000). This creates taxable income of $4,000 ($6,000 x 2/3).

 

Technically, what happens with the conversion of the nondeductible IRA transfer to the Roth is that the IRS looks at all your IRA accounts and excludes only those monies that are basis.(5)

 

Note. In the traditional IRA, you make a deductible contribution, and your earnings accrue tax-free until you take them out. You have no basis in either the contribution or the earnings. At this point, all the money in the traditional IRA is untaxed money.

 

Make the Tax Go Away

 

The pro rata allocation rule does not include money in qualified plans, such as a 401(k). If you first roll over your traditional IRA into a 401(k) or other qualified plan, you avoid any tax hit when creating the backdoor Roth IRA.

 

Example. You roll over IRA #1 into your existing 401(k), so you now have no IRAs. Next you make the nondeductible contribution to a new IRA and then roll that over to the Roth IRA. Presto! No taxes.

 

TCJA and the Back Door

 

You may have worried that the Tax Cuts and Jobs Act (TCJA) destroyed the backdoor Roth. Fear not! Not only is the backdoor Roth still viable, but it appears that TCJA lawmakers recognized and blessed the strategy.


In footnote 269 of the massive House conference report, lawmakers stated: “Although an individual with [adjusted gross income] 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.”(6)

 

Also, in an article in Tax Notes titled “IRS Won’t Target ‘Backdoor’ Roth IRA Contributions,” Donald Kieffer Jr., tax law specialist (employee plans rulings and agreements), IRS Tax-Exempt and Government Entities Division, is quoted as saying that the backdoor Roth is “allowed under the law,” even though “I don’t think you’ll find any specific legal or IRS guidance that says that.”(7)

 

Step Transaction or Not

 

Some tax writers worry that the backdoor Roth could be undone as a type of step transaction, because the steps enable you to do something indirectly (contribute to a Roth) that you are not allowed to do directly, due to income limitations.(8)

 

Writers who have this concern (which we do not share) suggest that you can avoid the step transaction by putting time between the nondeductible contribution to the traditional IRA and the rollover to the Roth. This worry group says that the more time between the transactions, the less worrying you need to do.

 

Takeaways

 

If you are a high earner and you want to have a Roth IRA, you can use the backdoor Roth technique, which involves making a nondeductible contribution to a traditional IRA and then rolling that money into a Roth.

 

The backdoor Roth strategy has been around for a good nine years, and it has experienced no trouble that we are aware of, so we think it’s a good strategy. We also like the recent notations in the legislative history and the comments from the IRS spokesperson that show approval of the strategy.

 

Keep in mind that with some planning, you can avoid any taxes on the rollover. For example, if you have an existing traditional IRA, you can move those monies to your qualified plan to avoid having the backdoor strategy trigger some taxes.

 

And if you have no traditional IRA, the nondeductible contribution to the traditional IRA and the subsequent rollover to the Roth IRA triggers no taxes.

  1. Notice 2018-83.

  2. Ibid.

  3. IRS Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs), dated Dec. 21, 2018, p. 39; Notice 2018-83 (for 2019 numbers).

  4. See Reg. Section 1.408A-4.

  5. Ibid. (Q&A-7).

  6. H.Rpt. 115-466, p. 289.

  7. Tax Notes, July 16, 2018, p. 413.

  8. The U.S. Supreme Court first articulated what has become known as the “step transaction doctrine” in the 1935 case Gregory v. Helvering (293 U.S. 465) (1935). In that case, the court disallowed a multistep stock transfer whose sole purpose was to allow the taxpayer to avoid the taxes that would have been involved in a direct transfer by way of dividend. All steps of the transfer were technically legal, but the court concluded that the entire process was an “elaborate and devious form of conveyance masquerading as a corporate reorganization,” and one that fell outside the plain intent of the law.

*Shutdown Update: 01/13/2018 - Good News* by Daniel Dundon

The bad news is that the federal government is still shutdown but the good news is that somehow the IRS will be opening the E-file system Jan 28th, 2019 and will be issuing refunds! We aren’t sure if they will be issued on the normal schedule but they said refunds will be issued. Many of the hotlines that tax professionals use to resolve issues will still be down along with standard taxpayer customer service so things will get interesting.

Government Shutdown? No Refund For You! by Daniel Dundon

Everyone is hoping the political waves will be calmed prior to tax filing season. While the government is shutdown, a few “critical” functions will continue to operate. Even though tax return filing deadlines will still be enforced, the government will not be issuing refunds. They will still expect YOU to make payment and file timely but they won’t be making timely payments to you if going the opposite direction. Most of the ACS and collection functions are also suspended, making it hard for taxpayers who are actively working to resolve an outstanding tax issue with the IRS.

Unreimbursed employee expense deduction is gone. Will it hurt you? by Daniel Dundon

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In the new Tax Cuts and Jobs Act, the unreimbursed employee expense deduction is completely gone. This deduction was formerly located on line 21 of Sch A under “Job Expenses and Certain Miscellaneous Deductions” and was reported on form 2106. The total amount of the other deduction section had to total over 2% of your AGI but for most people that used the deduction, that wasn’t hard to achieve.

If you’re not familiar with this deduction, you most likely don’t use it because those who do generally spend a considerable amount of time documenting their employee expenses that are not reimbursed. Most of my clients are business owners so those expenses go on the business (Sch C, Corp or Partnership) but this deduction is for people who are required to spend their own money or use their own resources as an employee and are not paid back for it. Salespeople, railroad workers, construction workers, ministers and people that are required to drive a high number of miles in their own car without reimbursement are a few of the people that will be hit the hardest. If a sales person drove 20,000 miles in 2017 with their own car and was not reimbursed, they would be entitled to a $10,700 deduction on form 2106 (assuming that is over 2% of AGI and they itemize). That is a lot money in deductions that will disappear!

Someone I spoke with recently asked me if it was “totally gone”. Yes its totally gone. If you want to remain a W-2 employee and you are required to drive your own car or spend your own money for your job, you may want to consider renegotiating those terms with your employer. Company’s often use the line, “well, you can deduct it on your taxes”. Employees will need to come to terms with eating that cost or petitioning their employers to fork out the cash

IRS tracking Bitcoin? Yessir by Daniel Dundon

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Bitcoin is supposed to be completely anonymous and "untraceable" through it's encrypted network. But it was just discovered that the IRS has spent well over $100K on a proprietary software that tracks Bitcoin transactions and attempts to identify the individuals on both the buyer and seller side of the transaction. The vendor is named Chainalysis and their tracking tool is called "Reactor".

The Daily Beast discovered the contract between the IRS and Chainalysis where they expanded their order for additional licenses and services...sounds like they were happy with the product. You can view the contract and read more about it here.