It has come up often enough that I decided to talk about it.
The backdoor Roth.
What sets up this tax tidbit?
Being able to contribute to a Roth in the first place. More
accurately, NOT being able to contribute.
Let’s say that you are single and work somewhere without a
retirement plan. No 401(k), SIMPLE, SEP, nothing. You make $135,000.
Can you fund an Roth IRA?
Yep.
Why?
Because you do not have a plan at work.
How much can you fund?
$5,500. That becomes $6,500 if you are age 50 or over.
Let’s say you have a plan at work.
How much can you fund?
Nada.
Why?
Because you have a plan at work and you make too much money.
What is too much?
For a single person, $133,000. I question what fantasyland
these tax writers live in where $133 grand is too-much-money, but let’s move
on.
A Roth is a flavor of IRA. It is like going to Baskin Robbins
and deciding whether you want your chocolate ice cream in a sugar cone or
waffle cone. Either way you are getting chocolate ice cream.
Let’s say that someone wants to fund a Roth. Say that someone
is a well-maintained, moderately successful, middle-aged tax CPA with
diminishing dreams of ever playing in the NFL. He is married. His wife works. His
back hurts during busy season. His daughter never calls ….
Uhh, back to our discussion.
He has a no plan at work. His wife does.
So we know the income limits will apply, as (at least) one of
them is covered by a plan.
For 2017 that limit is $196,000.
Let’s say our tax CPA makes $18,000. His wife makes $180,000.
I see $198,000 combined. He is over the income limit.
Our CPA cannot contribute into a Roth, because a Roth is a
flavor of IRA and he has exceeded the income limits for an IRA.
I suppose our CPA can ask his wife to dial it back a notch. Or
get divorced.
Or consider a back door.
There are two things to understanding the backdoor:
(1)
We have discussed two types of IRAs: the traditional
(that is, deductible) and the Roth. There is a third, although he has moved out
of the house and rarely attends family events (at least willingly) anymore.
The third is the nondeductible. He
is the wafer cone.
You get no deduction for putting
money in. You will pay something when you take money out.
When you pull money out, you
calculate a ratio:
* Nondeductible
money you put in/total value of account *
That ratio is not taxable; the
balance is.
There is even a tax form for this
- Form 8606. You are supposed to use this form every year you make a
nondeductible contribution. I understand that there is a penalty for not doing
so, but I have never seen that penalty in practice.
And no one would do this if a Roth
is available. When you pull money out of a Roth, all of the distribution is
nontaxable (if you followed the rules). That result will always beat a nondeductible.
The Roth effectively killed the
nondeductible, which perhaps explains why the nondeductible is the unfriendly
and distant family member.
But the nondeductible has one
trick to its game: there is no income test to a nondeductible. Our tax CPA
cannot fund a Roth (went over the limit by a lousy $2 grand), but he can fund
that nondeductible. There is no deduction, but there will be no penalty for
overfunding an IRA, either.
(2)
But how to get this nondeductible into a Roth?
Call the broker and have him/her
move the money from an account titled “Nondeductible IRA FBO Cincinnati Tax
Guy” to one titled “Roth IRA FBO Cincinnati Tax Guy.”
This event is called a
“conversion.”
You have to pay tax on a conversion.
Why?
Because you are moving money that
has never been taxed to an account that will never be taxed. The government
wants its vig, and the conversion is as good a time to tax as any.
How much tax?
Here is the beauty: since our tax
CPA did not deduct the thing, tax law considers him to have dollar-for-dollar
“basis” in the thing. If he put in $5,500, then his basis is $5,500.
Say he converts it when it is
worth $5,501.
Then his income is $5,501 – 5,500
= $1.
Yep, he has to pay tax on $1 to convert
the nondeductible to a Roth.
But there
is ONE MORE RULE. Too often, tax commentators fail to point this one out, and
it is a biggie.
He is probably
hosed if he has ANY traditional (that is, deductible) IRAs out there. This
triggers the “aggregation” or “pro rata” rule, and the rule is not his friend.
Let’s
calculate a ratio.
The numerator is the amount he is converting: $5,500 in our
example.
The denominator is ALL the money in ALL his traditional/deductible
IRA accounts.
Say our tax CPA had $994,500 in his regular/traditional/free-range
IRA before the $5,500 backdoor.
He now has $1 million after the backdoor.
His ratio would be 5,500/1,000,000 = 0.0055.
What does this mean?
It means that the inverse: 100% – 0.55% = 99.445% of every
dollar will be taxable.
Counting with fingers and toes, I say that $5,470 is taxable.
The nondeductible saved him tax on all of $30, which appears
to meet the definition of “near useless.”
So much for that $1 of conversion income he was hoping for. He
got hung on the aggregation rule.
This is an extreme example, but any significant ratio is going
to trigger significant taxable income on the conversion.
Is this deliberate by the IRS?
Does Tiger chase little white balls?
Our heroic and stoic tax CPA has other IRAs. The backdoor Roth
has become unreachable for him.
Or has it?
Here is a thought: what if our tax CPA rolls ALL of his IRAs
into the company 401(k)?
COMMENT: I know I previously said he did not have a plan at work. Work with me here, folks.
He would have to call the 401(k) people and see if they permit
that. Federal tax law says he can, but that does not mean that his particular
plan has to allow it.
Let’s say he can.
He now has zero/zip/zilch in
traditional/deductible/sustainable IRAs.
Seems to me that he is back to converting for $1 in income,
per our first example.
And there is your backdoor.
