Obama Budget Would Prohibit Backdoor Roth IRAs

The rich want Roth IRAs like everybody else, but President Obama's just released FY 2016 budget proposes ending the popular strategy known as a backdoor Roth. It’s one of 10 revenue raisers listed under “Loophole closers” – totally separate from grabs from the rich like restoring the estate tax to a $3.5 million exemption, not indexed for inflation, and bumping the top capital gains rate to 28%. The 10 loophole closers would bring in $143 billion over 10 years; killing the backdoor Roth Individual Retirement Account would bring in $385 million, according to revenue estimates.

One unintended consequence of trying to kill off backdoor Roths is that the Administration has in effect given a tacit validation to the strategy, says IRA expert and CPA Ed Slott. “It seems to me they’re saying that was a good workaround, but we don’t want you to do it anymore,” he says.

Here’s the deal. You can only contribute directly to a Roth IRA if your modified adjusted gross income is under a specified limit, indexed for inflation. In 2015, the income phase-out range for taxpayers making contributions to a Roth IRA is $183,000 to $193,000 for married couples filing jointly, up from $181,000 to $191,000 in 2014.  For singles and heads of household, the income phase-out range is $116,000 to $131,000, up from $114,000 to $129,000.

With a backdoor Roth, it’s like money grows on trees. Maybe that’s why the Administration wants to prohibit it.

So how do you get a Roth if you earn too much? You can open a nondeductible IRA (that’s a regular, traditional IRA, just you don’t get the income tax deduction) and convert it to a Roth IRA–as Congress lifted any income restrictions for Roth IRA conversions back in 2010. You can contribute $5,500 a year (plus an additional $1,000 catch-up if you’re 50 or older). 

“A lot of people do it, anyone with income too high to do a direct Roth IRA contribution,” says Slott. “If you could move money from one pocket to another and now it grows tax-free who wouldn’t do it?

When you make a nondeductible contribution to a traditional IRA and you immediately convert it to a Roth IRA, 100% of the conversion is nontaxable, right? Not necessarily.

You may be asking yourself, how it could be taxable since you didn't get a tax deduction for the contribution to your IRA. What about the backdoor Roth IRA conversion strategy?

Before I get too far ahead of myself, let me back up and review some basics about taxation of deductible versus nondeductible IRA contributions and taxation of Roth IRA conversions that is relevant to this discussion.

Deductible vs. nondeductible IRA contributions

  Without getting into details, the ability to take a deduction for part or all of a contribution to a traditional IRA is dependent upon three things:

 Whether you're covered by a retirement plan at work

• Tax filing status
• Amount of modified adjusted gross income ("MAGI")

 If you're single and not covered by a retirement plan or if you're married and neither one of you is a participant in a retirement plan, then 100% of your contribution up to the limit is deductible. If this isn't the case, then the amount of your IRA deduction is dependent upon your MAGI and tax filing status.

 Taxation of IRA distributions that include nondeductible IRA contributions

 What happens when you eventually take distributions from your traditional IRA account that includes nondeductible IRA contributions? The good news is that your nondeductible contributions won't be taxed. All of your earnings, on the other hand will be included in ordinary income. This could be a significant amount assuming that you make nondeductible contributions over many years.

 The calculation of the taxable portion of distributions from a traditional IRA account that includes deductible and nondeductible contributions isn't simple. It takes into consideration the cumulative amount of previously-unused nondeductible contributions, or "basis," as a percentage of the previous end-of-the-year value of all of your traditional IRA accounts to determine the taxable amount of distributions in a particular year.

 Roth IRA conversion

 Getting back to the fact that all earnings on deductible and nondeductible traditional IRA contributions will eventually be taxable, is there a way to minimize the damage? The answer is yes, through a Roth IRA conversion. You can transfer, or convert, part, or all of your traditional IRA to one or more Roth IRA accounts. This will eliminate taxation of distributions from your Roth IRA accounts down the road, including all earnings from the date of conversion, provided you comply with certain rules.

 The trade off for obtaining this favorable result is taxation of the value of the transfer amount from your traditional to Roth IRA on the date of conversion. The conversion is treated as a withdrawal from your traditional IRA, except that the 10% early withdrawal penalty doesn't apply if you're under age 59-1/2.

 The simple backdoor Roth IRA conversion strategy

 The plot thickens. What if you made nondeductible contributions to the traditional IRA account that you're converting to a Roth IRA? Aren't the nondeductible contributions nontaxable? The answer is "yes," however, only in a limited situation.

 Let's suppose that you're 30 years old, you don't have any traditional IRA accounts, you make a maximum contribution of $5,500 to a traditional IRA, you're covered by a retirement plan at work, and your MAGI exceeds the level for receiving a deduction for your contribution. After your nondeductible traditional IRA contribution has been credited to your account, you can immediately do a Roth IRA conversion. Since there are no earnings, 100% of your conversion will be nontaxable. This is referred to as a backdoor Roth IRA conversion.