Roth IRAs are attractive retirement savings vehicles for many reasons, particularly if you expect to be in a higher tax bracket when you draw on those assets to help fund your retirement needs. This is because although contributions to a Roth are not deductible for income tax purposes in the year they are made, qualified withdrawals of both principal and earnings from a Roth are income-tax free. Also, unlike traditional IRAs where you must begin taking withdrawals by age 70½, there are no mandatory distributions from a Roth IRA. This can make Roths an attractive vehicle for transferring assets to your heirs if you do not need the money for your retirement. In fact, according to the Investment Company Institute, among Roth IRA owners aged 70+, only 5.7% took distributions from their accounts.
However, due to limitations based on income and filing status (single, married or head of household), those who earn a fairly high income are prohibited from making direct contributions to Roth IRAs. Now, earning a high income is not a bad problem to have but it does mean that many professionals and business owners, including many doctors, dentists and practice owners, cannot contribute directly to a Roth IRA. Eligibility starts to “phase out” when a lower threshold income limit is reached, and is entirely eliminated at an upper threshold. For 2018, for those who file individual returns the phase-out begins at a modified adjusted gross income of $120,000 and no contributions are allowed for those with income greater than $135,000. For those who are married and file a joint return, maximum Roth IRA contribution amounts are reduced starting at $189,000, and reach zero when income exceeds $199,000.
Backdoor Roth IRA Contributions
One way for high income earners to still get the benefit of a Roth IRA is to contribute to a traditional IRA and then convert that traditional IRA contribution into a Roth IRA contribution. This is often referred to as making a “backdoor” Roth IRA contribution. Can this be legal? Actually, concerns about its legality in prior years have been laid to rest, because Congress officially approved this strategy as part of the 2018 tax reform law. For 2018, you can put up to $5,500 a year into a Roth IRA, or $6,500 if you are 50 or older.
Of course, there’s no such thing as “something for nothing” – the IRS will still be collecting money from you as part of this transaction. First, you have to make the contribution to a traditional IRA. Since this is an after-tax contribution, that income will have been taxed according to your current tax bracket (contrast that with a pre-tax contribution to a traditional IRA, which reduces your taxable income and therefore reduces your taxes).
The Step Transaction Doctrine – no longer a concern
Prior to the 2018 tax law, some tax professionals were leery of backdoor Roth IRA contributions because of the “step transaction doctrine” which would have prohibited high-income individuals from make Traditional IRA contributions and immediate, subsequent Roth IRA conversions as part of an “integrated strategy”. This is why you may have been advised to make a contribution to a Traditional IRA and allow some time to pass before converting that into a Roth IRA; by doing so, you would avoid having the IRS view it as an integrated transaction. Since the 2018 tax law officially “blessed” the backdoor Roth contribution, the step transaction doctrine is no longer an issue.
The Aggregation Rule
Here’s a “gotcha” – when you convert money from a traditional IRA into a Roth IRA, the total amount in the traditional IRA and in all of the traditional IRAs held in your name (indeed, many people have more than one IRA) is viewed as “contributing” to that conversion. In other words, it isn’t possible to convert a specific taxable contribution from a traditional IRA to a Roth IRA.
Converting any portion of any traditional IRA to a Roth IRA is considered a taxable distribution. The IRS’s Aggregation Rule says that when determining the taxes owed on this distribution, the total value of all IRA accounts must be added together, including amounts that were contributed on a pre-tax basis. If you have more than one IRA account in your name, they are all treated as one account and the “distribution” to the Roth IRA is deemed to have been made, pro rata, from each of your IRAs.
The practical effect of the Aggregation Rule is to reduce the appeal of backdoor Roth IRA contributions for some people. However, the Aggregation Rule applies only to your traditional IRA accounts; it does not include your spouse’s accounts, or any inherited IRAs or existing Roth IRA accounts, nor does it include most employer-sponsored retirement plans (with the exception of SEP IRAs and SIMPLE IRAs, which are included). Another thing that softens the blow of the Aggregation Rule is that personal income tax rates were reduced as part of the 2018 tax law, so your tax rate may be lower now than it was last year.
Another Option
So, it sounds like the people who would benefit from making a backdoor Roth IRA contribution are primarily high-income earners who do not already have a traditional IRA. However (stay with me here), there is another option that can make backdoor Roth contributions appealing, even if you have a traditional IRA.
You can roll pre-tax assets from your existing IRAs into an employer-sponsored retirement plan account, if your 401(k) or other plan permits rollover contributions. This “safely” transfers money out of your IRA without triggering a taxable distribution, so those assets would no longer be included via the Aggregation Rule.
Tax Effect in the Year of Conversion
For most high-income individuals with 401(k) or other tax-deferred savings plans, contributions to a Traditional IRA are not tax-deductible. Converting a Traditional IRA to a Roth IRA is a taxable event; however, the amount of the non-deductible contribution is, in effect, a return of principal when it is converted to a Roth IRA. So, taxes should only be owed on any earnings between the time of the original contribution to the Traditional IRA and the time of the conversion to the Roth IRA.
If you recently made a maximum Traditional IRA after-tax contribution of $5,500 (up to $6,500 if you are age 50 or older), converting it to a Roth IRA means you may be able to benefit from Roth IRA tax treatment with no taxable impact in the year of conversion.
Always consult your tax professional for specific details as to how IRA contributions or conversions will affect your specific tax situation.
Conclusion
Although high-income earners may not be able to make Roth IRA contributions directly, it may still be possible to enjoy the benefits of a Roth IRA by making a Traditional IRA contribution and then converting the account to a Roth IRA, keeping in mind the IRS’s Aggregation Rule.
To find out whether making “backdoor” Roth IRA contributions might make sense for your portfolio and financial situation, talk to your financial advisor and tax professional. It is especially important for physicians and others in the medical field to work with financial and tax advisors who have experience with the complex financial planning needs of professionals in this area.
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