BACKDOOR ROTH IRAs.

Author:Rinier, James W.
Position:TAXES
 
FREE EXCERPT

Taxpayers can initiate a backdoor Roth IRA transaction if they can't make a nondeductible contribution to a Roth IRA due to income threshold limits. But there can be consequences at tax time.

SOME TAXPAYERS CAN'T MAKE a non-deductible contribution to a Roth IRA if their income exceeds the annually adjusted threshold limits. For 2019, the threshold levels are $203,000 for married filing jointly, $10,000 (yes, $10,000--that isn't a typo) for married filing separately, and $137,000 for all other taxpayers. A taxpayer with earned income (regardless of the amount), though, can make a nondeductible contribution to an IRA if he or she isn't yet 70-and-a-half years old. Once Congress removed the $100,000 adjusted gross income (AGI) limit on converting IRA funds to a Roth IRA in 2010, the stage was set for the introduction of the backdoor Roth IRA.

A backdoor Roth IRA transaction begins with a taxpayer making a nondeductible contribution to a newly created traditional IRA. Next, the funds are transferred to a Roth IRA. On the surface, the transaction is simple. So what are the real and possible hazards that a person should keep in mind?

In a typical situation, the taxpayer already has an existing IRA with previously deducted or nondeducted contributions and untaxed earnings. In this case, the taxpayer makes a nondeductible contribution to his or her IRA and then converts some of the amount into his or her Roth IRA. But the conversion requires the taxpayer to determine the taxable and nontaxable portion of the converted amount pursuant to the IRC [section] 72 rules. Although the rules aren't difficult, the conversion will be partly taxable, which defeats the objective of contributing to a Roth IRA. And it doesn't matter if the taxpayer has one or more traditional IRAs, a Simplified Employee Pension (SEP), or a Savings Incentive Match Plan for Employees IRA (SIMPLE IRA)--they're all treated as a single IRA for this transaction.

AVOIDING THE PROBLEM

One way to circumvent this dilemma is to transfer (i.e., through a direct rollover) all the pretax IRA holdings into the taxpayer's employer's qualified plan, e.g., a 401(k), 403(b), or 457 plan. If the employer's plan allows the transfer, the rollover is nontaxable. Alternatively, the taxpayer might convert all the IRA holdings into his or her Roth IRA and include the pretax amount in gross income. This transaction is partially taxable and may not be appealing to the taxpayer. Once the IRA is (or IRAs are)...

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