Setting Up the ConversionThe first step to executing a Roth conversion is having a Traditional IRA, which is available to most employed investors regardless of income level. Next, determine the tax consequences associated with a Roth conversion. Most accountants or CPAs can run projections for you if needed, but suffice to say, any pre-tax contributions or any rollovers from employer sponsored plans will be subject to taxation at your tax rates and the same thing will happen to any investment earnings that are currently tax deferred. Once you understand the potential tax consequences, develop a strategy for paying the tax bill when it comes due. Please understand that any tax withholdings from the IRA are considered distributions and will be subject to taxes and potential early distribution penalties. Thus, most Roth conversion candidates prefer to pay any tax liability from other cash or investment accounts. To avoid a large tax bill, some investors prefer to only convert IRA contributions that were made with after-tax dollars and that have minimal investment earnings (a.k.a. “Back-door Roth”). Here are few risks to understand before executing this transaction (this list is not meant to be all-inclusive): First, IRA Aggregation rule under IRC Section 408(b)(s) (a.k.a. Pro Rata IRA Distribution Rules): When a Roth conversion occurs, the taxpayer must calculate the income tax consequences of a Roth conversion by aggregating together all of the taxpayer’s IRAs. If the accounts as a whole have a mix of pre-tax and after-tax contributions, the conversion is assumed to be a pro rata mix of the pre-tax and after-tax contributions. “Cherry picking” which contributions to convert is not an option. Thus, in order to avoid this issue, most investors will try to move any pre-tax contributions and investment earnings to 401(k) type plans.3 Second, the Step-transaction doctrine: Tax liability should be determined by viewing the transaction as a whole, disregarding the fact that several tax advantaged “legal” steps took place before the final result. Had the same result happened by taking different steps, the transaction would not have the same tax advantages. Congress has set income limits for contributions to Roth IRAs. These income limits do not currently apply to Roth Conversions. Most anyone with earned income or who has a spouse with earned income can contribute to a Traditional IRA. There are limits on who can deduct those contributions on their tax return, but there are no income limits on who can contribute. Thus, a person who makes a non-deductible contribution to Traditional IRA and subsequently converts the account to a Roth IRA (i.e. “Back-door Roth”) may be viewed by the IRS as directly contributing the Roth IRA. If their income exceeded the limits when the Roth contribution was made, the client has made an excess contribution that must either be unwound or be subject to the 6% excess contribution penalty tax.4 Next, most investors prefer to open up a Roth IRA at the same fund company or custodian as the IRA they plan to convert. This is not mandatory, but it makes the process a little easier. This is similar to the process of opening a traditional IRA. It is important not to put off a conversion until the last minute, as the financial institution may be inundated with similar requests as the deadline approaches. Check with your investment custodian to see if they have any kind of cutoff date for initiating this request. The final step is to report the conversion on IRS form 8606 when completing your taxes. It’s highly recommended that you work with a tax professional who is familiar with Roth conversions at this juncture to help you avoid any errors, which could lead to potential headaches with the IRS down the road.5
Weighing the BenefitsOne last point of consideration: Tax-free withdrawals from Roth IRAs involve withdrawing your contributions and earnings per IRS guidelines and U.S. tax law. However, this characteristic does not make the Roth IRA completely “tax-free”. Here are a few examples of Roth IRA assets being subject to potential taxation. One, you have to pay tax on any earned income or pre-tax IRA contributions prior to the money going into the Roth IRA. Two, at death, Roth IRA values are included in the total value of your estate, which means it may be subject to potential estate taxes. Three, any distributions of earnings before age 59 ½ or distributions of funds converted in the last 5 years may be subjected to taxes and early distribution penalties.6 At the end of the day, weigh the benefits against the potential costs before executing a Roth conversion. A financial advisor can help you determine if the Roth conversion may make sense in the long run based on certain assumptions. You may find out that retiring earlier is an option or you may find out that the potential reward is not worth the risk. To understand your actual or projected tax consequences in more detail, engage the services of an experienced CPA or other tax accountant. To understand the asset protection qualities of IRAs more, engage a competent asset protection attorney who can provide you guidance on which accounts fair better in legal situations. References:
- James M. Dahle, MD, “Backdoor Roth IRA Tutorial” (January 2014). http://whitecoatinvestor.com/backdoor-roth-ira-tutorial/
- Dan Moisand, “Be Sure to Know How IRA Contribution and Conversion Deadlines Differ” (August 2016). http://www.marketwatch.com/story/be-sure-to-know-how-ira-contribution-and-conversion-deadlines-differ-2016-08-19
- Christine Benz, “Backdoor Roth IRA? Avoid These 6 Mistakes” (March 2015). http://news.morningstar.com/articlenet/article.aspx?id=687449
- Johanna Fox Turner, CPA, “What is the deadline for converting an IRA to an Roth-IRA using the backdoor strategy?” (December 2014). https://www.nerdwallet.com/ask/question/deadline-converting-ira-roth-ira-backdoor-strategy-18279
- New Direction IRA, Inc, “Roth Conversion Limits, Deadlines, and Rules” http://news.morningstar.com/articlenet/article.aspx?id=687449
- Emily Brandon, “Fewer People Pay IRA Early Withdrawal Penalty” (August 2015) http://money.usnews.com/money/blogs/planning-to-retire/2015/08/28/fewer-people-pay-ira-early-withdrawal-penalty
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