Taxpayers are allowed to contribute up to $5500 to regular or Roth IRAs for 2017, the same contribution limits as for 2016. For taxpayers age 50 or older, an additional “catchup” contribution amount of up to $1000 can be made.
Roth IRAs can be a great retirement savings vehicle and can outperform regular IRAs in terms of after-tax net benefit in many cases when left to grow over many years and can provide other estate planning advantages. A big challenge for many taxpayers however is the income phase-out threshold for Roth contributions.
For single filers, the ability to make Roth IRA contributions phases out between $118,000 to $133,000 of income for 2017, up slightly from the $117,000 to $132,000 range for 2016. For married joint filers the phase-out range for 2017 is between $186,000 to $196,000 of income, up slightly from the $184,000 to $194,000 phase-out range for 2016.
A possible workaround to the income phase-out ranges for high income taxpayers it the Backdoor Roth strategy. This strategy is fairly simple and works as follows:
Step 1- Taxpayer makes a nondeductible regular IRA contribution up to the $5500 (or $6500 if catchup applies) limit. The contribution is nondeductible when the taxpayer’s income is above the threshold for deducting regular IRA contributions, which often occurs when the taxpayer or their spouse is a participant in an employer retirement plan. Because the contribution is nondeductible, the taxpayer gets tax basis for the contribution.
Step 2- Taxpayer then immediately does a Roth conversion on the nondeductible IRA by moving the contribution amount to a Roth IRA account. There is no income limit for Roth conversions. A Roth conversion is normally taxable income, but because the taxpayer got no tax basis from the nondeductible IRA contribution, no amount of the conversion amount is taxable other than any small amount of income earned between contribution and conversion.
Step 3- The nondeductible IRA contribution and Roth conversion amounts are reported on Form 8606 for that tax year, which is normally submitted with Form 1040.
Important- For this strategy to work and avoid significant ordinary income tax on the Roth conversion in Step 2, the taxpayer cannot have any substantial existing regular IRA account balances, including SEP and SIMPLE IRAs. Otherwise the conversion allocation rules will force allocation of some of the Roth conversion amount to prior IRA amounts that do not have tax basis, thereby making some of the conversion amount currently taxable. The deadline for funding any IRA contributions for 2016 is the same as the individual income tax return due date for that year, April 18, 2017.
Some practitioners have raised concerns over this strategy being potentially subject to the Step-Transaction Doctrine, whereby IRS can view a series of steps as an impermissible single tax avoidance transaction. One approach to guarding against that would be to wait some period of time after the IRA contribution date before doing the Roth conversion. But the longer wait period, the more risk that some of the conversion amount may be taxable due to income or value accruing.
This strategy is not right for everyone, but for some taxpayers it can be a great way to build up substantial Roth IRA balances over time. Please contact us if you have questions or would like to explore this strategy for your tax situation.