Executive Summary
As a part of the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), income limits on Roth conversions were repealed, starting in 2010. However, while TIPRA removed income limits for Roth conversions, it did not eliminate the income limits for new Roth contributions.
As a result, a new creative use of Roth conversions opened up: just contribute to a non-deductible traditional IRA, and then complete a Roth conversion immediately thereafter. Since neither transaction individually has a contribution limit, the client can still get money into a Roth IRA each year, regardless of the still-remaining income limits on Roth contributions. The end result: accomplishing a "backdoor Roth IRA contribution" for someone who wouldn't normally be eligible to make a Roth IRA contribution in the first place.
There's just one problem: the IRS can still call a spade a spade, and the rising abuse of this backdoor Roth IRA contribution "loophole" may bring about its permanent end.
The inspiration for today's blog post comes from a recent article from Forbes, entitled "The Serial Backdoor Roth, A Tax-Free Retirement Kitty" which suggests taxpayers may routinely engage in the contribution-then-convert Roth strategy with impunity. The approach is simple: contribute up to $5,000/year (or $6,000 with catch-up contributions for those over age 50) to a non-deductible IRA, and then convert the IRA to a Roth. Since neither transaction has an income limit, and the non-deductible IRA includes entirely after-tax contributions, the end result is that the client annually completes the equivalent of a Roth contribution, neatly dodging the existing Roth contribution income limit while having no immediate tax impact (since the non-deductible IRA contribution has no tax consequences, nor does the Roth conversion of an IRA whose non-deductible contributions equal its current value).
IRA Aggregation Rule
The article does highlight the most direct complication of the strategy as well - the IRA aggregation rule under IRC Section 408(d)(2). The rule stipulates that 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; as a result, other pre-tax IRA funds can distort the tax consequences of the contribute-then-convert strategy. For example:
Assume Andrew contributes $5,000 to a non-deductible IRA with the intention of converting it. However, Andrew also has a $150,000 pre-tax IRA, the accumulation of several prior 401(k) rollovers, and $12,000 of non-deductible contributions from many years ago. When Andrew converts his newly created $5,000 non-deductible IRA, he cannot simply convert at a tax cost of $0. Instead, the IRA aggregation rule applies. His total non-deductible contributions are $12,000 + $5,000 = $17,000, and his total IRAs are $150,000 + $5,000 = $155,000. Accordingly, when Andrew converts the $5,000 non-deductible IRA contribution, the portion that is non-taxable will be $17,000 / $155,000 = 10.97%, or $549. The remaining $4,451 will be taxable income, due to the application of the IRA aggregation rule; this result occurs even if all the new non-deductible contributions are made to a separate account which is converted all by itself!
Beware The Step Transaction Doctrine
However, the greatest complication - not expressly stated in the article, although indirectly implied by IRA expert Bob Keebler's comments at the end - is not merely the application of the IRA aggregation rule. It is the risk that the IRS will apply the step transaction doctrine to an attempted backdoor Roth IRA contribution, invalidating the strategy entirely.
The step transaction doctrine is the legal principle that a series of related steps in a transaction should be taxed based on the overall economic nature of the transaction, not "just" based on the separate individual steps. In the context of the contribute-then-convert strategy, the step transaction doctrine would examine the overall result of the transaction - dollars came out of a taxable account and ended up in a Roth IRA - and tax it according to the substantive result that occurred: that the taxpayer constructively made a contribution to a Roth IRA. After all, the taxpayer contributed to the non-deductible IRA for the sole purpose of converting it to a Roth IRA, and did those two steps together for the sole purpose of getting a new annual contribution into a Roth IRA. In the end, the net result is that the taxpayer constructively made a Roth IRA contribution. According to the step transaction doctrine, if that's "really what happened" then the IRS can call a spade a spade, and tax it accordingly.
Of course, Roth IRA contributions themselves are not actually taxable anyway. They are a contribution of after-tax funds in the first place. But treating the transaction as being substantively the same as a Roth IRA contribution does mean that the client now made a Roth IRA contribution while his/her income is too high (assuming that's the case; otherwise the client would simply make a direct Roth IRA contribution in the first place!). And if 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. Thus, if the step transaction doctrine adjusts the strategy to be "what really happened" - a Roth IRA contribution - then when the IRS "taxes" it accordingly, it may assess the penalty tax for excess contributions if income was, in fact, too high. And if the strategy is implemented repeatedly for years, the client could face an excess contributions tax of 6%, per year, per contribution, for as far back as the statute of limitations allows (in addition to being responsible for unwinding the contribution itself, along with all subsequent earnings).
So does the strategy of contributing to a non-deductible IRA and converting it to a Roth IRA to avoid the Roth IRA contribution income limit constitute a step transaction scenario? The reality is that the application of the step transaction doctrine is done on a case-by-case basis, and depends on a subjective interpretation of the facts and circumstances of the client's particular situation. What do the courts look for in evaluating the potential of a step transaction? Simply put, they are looking for a series of transactions, all inter-related, where the final outcome of the overall series of transactions was to accomplish the equivalent of another single-step (or fewer steps) transaction. In the case of a client who contributes to a non-deductible IRA, specifically for the purpose of converting it, and does those multiple steps precisely because it is a way to try to avoid the Roth IRA contribution income limits, then it seems clear that the step transaction doctrine could be applied. In point of fact, it is exactly these kinds of scenarios - multiple related transactions done to obfuscate the tax consequences of the same event in a single transaction - that the step transaction doctrine was designed to address (in the interests of reducing "abusive" tax avoidance strategies)!
Avoiding The Step Transaction Doctrine With A Small Wait
The easiest way to make the case that the step transaction doctrine shouldn't apply is the passage of time, and the possibility that the tax and economic situation could change between the steps. Although a pre-meditated to decision to contribute to a non-deductible IRA with the specific intention to convert it shortly thereafter can be viewed unkindly by the IRS over any time period, an individual who has contributed to non-deductible IRAs in the more distant past and now chooses to convert is less likely to face scrutiny than someone who completes the conversion just a few days later.
Many taxpayers choose to implement the backdoor Roth IRA contribution strategy more "safely" by converting a prior year's non-deductible IRA contribution, and then making a new non-deductible contribution for the current year, specifically to introduce at least some economic uncertainty to the situation, reducing the likelihood of step transaction treatment. A 12-month waiting period between contribution and subsequent Roth conversion would also be consistent with a similar strategy to avoid the step transaction rule for a partial 1035 exchange and subsequent surrender, where the IRS actually has affirmed that a 12-month waiting period is sufficient to avoid unfavorable treatment.
It's also notable that step transactions are not something that is typically captured in the "automatic reporting" processes for non-deductible IRA contributions and Roth conversions on IRS Forms 1099-R and 5498 and the tax return itself with a supporting Form 8606. Accordingly, many clients may choose to "take the gamble" and proceed with such a transaction anyway, under the auspices that there is a low probability they will be caught. While that may be true, it does not change the fact that the client would face a high risk of losing, if he/she was caught, if the IRS and/or the courts decided to view the transaction through the lens of the step transaction doctrine.
In the end, the contribute-and-then-convert strategy is not expressly prohibited by the tax code, but the IRS does have the right to tax a transaction according to its true economic reality. And if the express goal and intent of the client is merely to circumvent the clear intent of the law, and is done in a manner that blatantly disregards it, beware. While the reality is that the likelihood of getting caught is extremely low, when the IRS believes that a transaction is abusive, not only do they act to shut it down, but they don't always provide leniency for those who have already tried to take advantage of it in the past.
(Editor's Note: A few people have pointed out this article by Ed Slott from last April suggesting that the step transaction doctrine doesn't apply to the contribute-then-convert strategy. However, in reality, Slott acknowledges in the article that it is possible the IRS will raise step transaction issues with the strategy in the future. He simply believes it's "not likely" that they will do so, and in agreement with today's blog post, encourages some passage of time to make a distinction between the steps to reduce the risk {although he still suggests a fairly brief time window of days is sufficient}.)
It seems that if the IRS didn’t want people to follow this strategy then they should have left the conversion income limits in place or raised the conversion limit from $100k to the current Roth contribution phase-out beginning amounts. ($107k-Single / $169-MFJ)
This seems like it should have been such an obvious strategy to them that since they didn’t state any rules to prevent it, they were ok with it. How can we properly plan/advise our clients if we are not sure what rules we have to follow? If they don’t want taxpayers to follow this strategy (contribute then convert) they need to spell it out.
William,
The removal of the income limits was not done by the IRS. It was enacted by Congress with a very delayed implementation provision. Congress writes the laws; the IRS’ responsibility is to ensure people follow the law as it was intended.
If Congress did NOT want an income limitation on Roth contributions, they could just remove it. The fact that it remains is a direct signal from Congress that the intention of the law is that Roth contributions are still limited by income. Accordingly, it’s the IRS’ responsibility to enforce that law – which means NOT allowing taxpayers to circumvent Congressional intent by obfuscating the law through a series of individual steps that still add up to the same economic result.
Respectfully,
– Michael
Michael,
The conclusion you are drawing in “If Congress did NOT want an income limitation on Roth contributions, they could just remove it” is not correct.
The reason why they don’t remove the income limitation has to do with the pro-rata rule.
What congress wants is to collect taxes. Here is how they do it. When you do a Roth conversion, you have to follow the “pro-rata” rule. Suppose you have 200k in an IRA that was funded with 100k non-deductible contributions, and you want to convert 100K to Roth, then you would pay taxes on 50K!
The above case really is the main idea behind the law. Congress wants to collect taxes by only allowing people to convert a “fraction” of their IRA rather than allowing them to just convert the non-deductible amount in their IRAs! In other words, the pro-rata rule is very central to Roth conversions.
To explain further why I disagree with your reasoning. If Congress had just lifted income limitations, it would have created a path for high-income earners (which often have well-sized IRAs) to get money into a Roth, but avoiding to pay taxes (which they would otherwise have to under the pro-rata rule).
The law has a lot of weaknesses introduced by the fact that IRAs and 401ks etc are treated differently wrt the pro-rata rule. That very weakness makes it however also impossible to state the exact “intention” of Congress wrt high-income taxpayers.
In summary, the law is quite imperfect and its only “clear” intention is to collect taxes “now” rather than “later”.
Suppose a high-income taxpayer utilized the contribute-and-convert strategy at some point in the past, say 2010. Is there some period of time beyond which the IRS cannot challenge the transaction?
I ask because it is my understanding that if a high-income taxpayer makes a prohibited (i.e., excess) contribution directly to a Roth IRA, the excess contribution causes a penalty to accrue indefinitely, i.e., every year until it is removed. In effect there is no statute of limitations for an excess contribution.
2014 will be year 5 for me on the Backdoor Roth IRA. I guess I’ll start worrying about the step doctrine when I hear about someone who has actually had theirs disallowed. There are tens of thousands, perhaps even millions doing this every year and we haven’t heard about anyone who had it disallowed?
It’s like the speed limit. If the cops aren’t going to pull me over until I’m 6 over, then the speed limit is in essence 5 mph faster than posted. If the IRS isn’t going to disallow the backdoor roth, then I guess it’s okay.
Besides, if they give clear guidance (must wait a week, 3 months, a year etc), then we’ll all just start doing that and in the end, it’ll be the same effect. No wonder they’re not enforcing it.
So far I’ve only heard of one person who actually has an IRS agent disallow this on audit. But bear in mind, because the 6% excess contributions tax is reoccurring for every year it’s not collected, the statute of limitations never closes on this (because it renews itself annually).
So frankly, the IRS has little need to expedite their crackdown on this. They can “get around” to tackling it anytime they wish, and begin to collect years’ (or a decades’?) worth of penalties when they choose to do so, if the original transaction was done without an appropriate waiting period.
I just don’t understand why someone would want to gamble a decade+ of cumulative penalties when a simple waiting period from contribution to conversion would entirely eliminate the exposure. And incidentally, “the IRS won’t pursue it” was the same argument made for years about partial 1035 exchanges and subsequent surrenders until the IRS did, in fact, address it and require a mandatory waiting period to address the implicit step transaction. So there is precedent in similar contexts.
– Michael
I think it would be interesting to try to get a determination letter (or whatever one calls it in personal income taxes; I work on pension plans and that’s what we called it) on the practice.
I’ve been doing the backdoor Roth since 2010, sometimes (like last year) contributing and converting on the same day — I hadn’t heard of the step transaction issue before.
Before I go back and try to figure out how to “correct” what I’ve done, I’d be happy to pay the user fee to get a determination on the practice. Heck, I’d even be okay getting hit with the excise taxes (we’re only talking four years at this point) because at least I’d _know_.
I have done the taxable IRA to Roth conversion for past 5 or so years. But I also converted my outstanding IRA to a Roth and paid tax since it was originally all non-taxable contributions or gains.
So I couldn’t have the graduated penalty assessed–
what would trigger the IRS to notice something like this conversion?
As part of an audit for something else?
MIchael,
Why do you say, “just don’t understand why someone would want to gamble a decade+ of cumulative penalties when a simple wating period from contribution would “entirely” eliminate the exposure.”
Is it not true that there is no way of knowing what an acceptable waiting period is? I believe the article makes this point. So for example, even if someone were to make a non-deductible contribution in January of year 1 and then do a roth coversion in Feb of year 2, then make another non-deductible contribution in April of year 2 and make a roth conversion in June of year 3, then make a another non-deductible IRA contribution in July of year 3 and make a roth covnersion in September of year 4 and continue doing this every year indefinitely, would it not be clear to the IRS that this taxapayer was indeed circumventing the law based upon this pattern of behavior?
I suppose what I am saying is that if there is a long enough period of history for the IRS to look at with respect to a taxpayer, it is possible that there is no waiting period that is long enough to defend against a pattern of behavior like this?
Mike
I now see that this exact question was discussed in this subsequent blog written in August 2015 (with further discussion in the comment section of that blog):
https://www.kitces.com/blog/how-to-do-a-backdoor-roth-ira-contribution-while-avoiding-the-ira-aggregation-rule-and-the-step-transaction-doctrine/
Good follow up blog. I think you’ve said all that can be said on this topic at this point.
Happy to be of service Mike! I hope it helps as food for thought! 🙂
– Michael
Another approach to avoiding (or appearing to avoid) the Step Transaction Doctrine would be to vary the amount of the conversion. If you contribute take the example of Andrew in the article, he contributed $5K but had an additional $150K in other Traditional IRA assets. If he then converts not $5K, but $4K or $6K (or $10K), that would make it difficult to say this is a multi-step process of contributing $5K to a Roth IRA when it would not be otherwise allowed.