The ERISA consultants at the Columbia Management Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. A recent call with an advisor in Texas is representative of a common inquiry involving Roth IRAs and 401(k) plans. The advisor asked:
“One of my colleagues mentioned he discussed a “backdoor” Roth IRA with one of his clients who was not eligible to make a deductible traditional or Roth IRA contribution because of her income level. What is a backdoor Roth IRA?”
Highlights of Discussion
• You won’t find the phrase “backdoor Roth IRA” in the Internal Revenue Code or Treasury regulations. Nor is it a specific product. A backdoor Roth IRA is merely a series of transactions or steps a traditional IRA owner can take to achieve the end result of a tax-free conversion to a Roth IRA.
• In order to take advantage of this strategy, a taxpayer would need to have a workplace retirement plan that accepts rollovers from IRAs, a traditional IRA and a Roth IRA.
• Anyone under the age of 70-1/2 with earned income can make a nondeductible contribution to a traditional IRA regardless of income level.
• The IRS allows the owners of traditional, simplified employee pension (SEP) and savings incentive match plans for employees (SIMPLE) IRAs to roll over their IRA assets to their workplace retirement plans, but only those IRA assets that are pre-tax (i.e., deductible contributions along with any earnings), as long as the plans allow for IRA rollovers.
• An investor can determine whether his or her workplace retirement plan permits IRA rollovers by examining the summary plan description (SPD) for the plan.
• This “pre-tax only” rollover rule works to an IRA owner’s benefit for Roth IRA conversion purposes. If the plan permits IRA rollovers in, the investor can roll over the pre-tax money into a rollover account within the employer’s plan. This will greatly improve the investor’s conversion taxation ratio within his IRAs. After the rollover is complete, the investor can convert the remaining after-tax assets in his traditional IRAs to a Roth IRA — tax free.
EXAMPLE: Gram has a traditional IRA with a balance of $135,000 (including $28,000 of nondeductible or after-tax contributions). He is self-employed and decides to establish an individual 401(k) plan for his business, which allows for IRA rollovers. He rolls his pre-tax IRA balance of $107,000 into his individual 401(k) plan, leaving behind the $28,000 of after-tax assets in his IRA. Because 100% of his traditional IRA now consists of after-tax assets, his conversion to a Roth will not result in any income that would be subject to taxation (provided no additional earnings accumulate before he completes the conversion).
• A word of caution: This approach should be carefully reviewed to determine if it will disrupt any long-term investment strategies of the investor and/or result in added fees or expenses.
• Note that the April 2013 issue of the Journal of Accountancy contains an article, “Making a Backdoor Roth IRA Contribution,” that supports this strategy.
The Columbia Management Retirement Learning Center Resource Desk is staffed by the Retirement Learning Center, LLC, a third-party industry consultant that is not affiliated with Columbia Management. For informational purposes only. Please consult a tax advisor or attorney for specific tax or legal needs. © 2013 Columbia Management Investment Advisers, LLC. Used with permission.
