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Backdoor Roth IRAs and Skinny Lattes

By John Mlynczyk

Roth IRAs are excellent retirement and estate planning vehicles.  Roth IRAs provide for tax free growth on your investments and tax free distributions at retirement.  That’s great!   However, many taxpayers cannot make direct contributions to Roth IRAs.  In fact, married taxpayers filing a joint return cannot make direct Roth contributions if their adjusted gross income (AGI) is $196,000 or more.  Single taxpayers cannot make direct Roth contributions if their AGI is $133,000 or more.  These taxpayers should consider a “Backdoor” Roth IRA as a great tax planning strategy.

By way of background, understand that there are two flavors of IRA contributions, Roth and traditional.  Think of the Roth IRA as the good old straight drip coffee.  Think of the traditional IRA as your favorite latte.  For this purpose all you need to know is that your latte is offered in traditional full-fat (tax deductible) and skinny (non-deductible) versions.

While many taxpayers are not eligible for the drip coffee (Roth IRA), they may also not be eligible for traditional full-fat lattes (i.e. the more favorable tax deductible IRAs).   In fact, married taxpayers filing a joint return that participate in a qualified retirement plan at work (such as 401k plan) and have AGI of $119,000 or more cannot make deductible IRA contributions.  Special rules also limit deductible contributions when one spouse is covered by a qualified plan while the other spouse is not covered.  Single taxpayers with AGI of $72,000 or more also cannot make tax deductible IRA contributions.

This leaves many taxpayers with only one coffee option, the skinny latte (i.e. the non-deductible IRA). Like its coffee counterpart, the non-deductible IRA contribution may seem less satisfying.  Said differently, taking away the tasty fats and sugars is like taking away the more desirable tax deductions!  However, some taxpayers may be able to exchange their skinny lattes for traditional drip coffee (i.e. the Backdoor Roth IRA Conversion).

It is true that the IRS allows you to convert your non-deductible IRA to a Roth IRA.  This is more commonly known as a Backdoor Roth IRA conversion.  Your investment advisor will actually set up two accounts (traditional and Roth).  You make the annual contribution to the traditional account (albeit a non-deductible contribution) then the advisor converts it to the Roth account the next day.  Sound like a loophole?  Well, sort of.

For many taxpayers this is a great strategy.  They can make annual contributions to non-deductible IRAs then immediately convert to Roth.  This becomes a systematic way to build up their Roth IRA accounts over their working careers.

However, for some taxpayers this strategy is a bit problematic.  This problem extends to taxpayers that have existing tax-deferred traditional IRA accounts and taxpayers that previously rolled employer 401k accounts to an IRA.

Converting from a non-deductible traditional IRA to a Roth is a taxable event.   You first look at the value converted (say $5,500) vs. the tax basis in the amount converted.   If the tax basis in the amount converted is a full $5,500, then there is no taxable gain on the conversion.  (Great news!)

However, the “coffee and cream” rule requires you to compute your tax basis globally across all of your IRA accounts using a relative ratio.  The rule says that any pre-existing tax deferred IRAs (traditional IRAs or rollover IRAs) will dilute your tax basis upon conversion.  This creates a tax liability upon conversion effecting those taxpayers with existing tax deferred IRAs or rollover IRAs.

For example, suppose your current year non-deductible contribution is $5,500 (full tax basis because it was non-deductible).  However suppose you also have a rollover IRA from your old 401k plan worth $100,000 (with no tax basis).   Let’s also suppose you convert $5,500 from Traditional to Roth this year.  The result is that 5.2% ($5,500 / $105,500) of your total IRAs is coffee (with tax basis) and the rest of your IRA is cream (without any tax basis).  In this example, $5,214 (94.8%) of the amount converted is cream (i.e. taxable!).  Said differently, once you have mixed coffee with cream, you cannot take a sip of the coffee without drinking both.

Backdoor Roth IRAs can be a powerful planning tool and a great strategy for taxpayers with the right circumstances. But due to the coffee and cream rule, the strategy doesn’t work well for all taxpayers.  You should always consult your tax advisor before committing to a Backdoor Roth IRA tax strategy.