Many CPAs are aware of the “backdoor” Roth IRA technique.  But many have also wondered about whether the IRS might challenge this technique given that it, first, has gained a name that sounds like a “cheat” and, second, it is clearly trying to work around the contribution limits Congress has left in the law even after removing the income limits on converting a regular IRA to a Roth IRA.  But now we have at least an unofficial blessing of the technique from an IRS employee on an IRS sponsored broadcast.

Tax Analysts reported in the July 11, 2018 edition of Tax Notes Today that Donald Kieffer Jr., tax law specialist (employee plans rulings and agreements), IRS Tax-Exempt and Government Entities Division made favorable comments about the technique in a Tax Talk Today webcast broadcast on June 10. [1]

Per IRC §408A(c)(3), the ability of a taxpayer to make a Roth IRA contribution is limited based on adjusted gross income.  For 2018 the taxpayer’s ability to make a Roth IRA contribution phases out over the following adjusted gross income phase out ranges:

• Married filing a joint return: $189,000 - $199,000
• Single and head of household: $120,000 - $135,000
• Married filing a separate return: $0 - $10,000. [2]

However, under IRC §408A(d)(3) a taxpayer may rollover funds to a Roth IRA from a traditional IRA regardless of the taxpayer’s adjusted gross income level.  In that case the taxpayer will be treated as taking a taxable distribution from the IRA, with the taxable amount determined by reducing the distribution by the basis in the IRA allocated to that distribution.

The “backdoor” contribution works best when a taxpayer has no traditional IRA accounts prior to beginning the process of making the backdoor contribution.  The taxpayer opens a traditional IRA and makes a non-deductible contribution to the account.  So long as there is sufficient earned income and the taxpayer is not over age 70 ½, a non-deductible contribution is always available to the taxpayer regardless of income.

Later, the taxpayer then rolls the balance of that IRA into a Roth IRA under IRC §408(d)(3).  Since the taxpayer had no other traditional IRAs, the entire contribution becomes basis in the IRA.  The taxpayer would then only pay tax on the earnings from the time the funds entered the traditional IRA until the account was rolled into the Roth IRA.

If the taxpayer already has a traditional IRA the backdoor rollover does not work as well, since the basis is spread over the entire balance of the account.  That creates, effectively, the taxpayer paying tax twice on virtually all of the rollover in many cases—one for the earned income allowing for the contribution and a second time on the rollover.  Thus, the technique is rarely used in such cases.

But let’s go back to when the math does make sense—can we really get around the deduction limits of IRC §408A(c)(3) via this trivial workaround for a taxpayer who does not currently have a traditional IRA?

Mr. Kieffer indicated the answer is yes, based on a footnote in the conference report to the Tax Cuts and Jobs Act that stated:

Although an individual with [adjusted gross income] exceeding certain limits is not permitted to make a contribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA. 

The Tax Analysts article quotes Mr. Kieffer on the subject as follows:

“I think the IRS’s only caution would be whenever we see words like ‘back door’ or ‘workaround’ or other step transactions that are putatively enabling a way to get around limits — especially statutory contribution limits — you generally find the IRS is not happy and prepared to challenge those,” Kieffer said. “But in this one that we’re talking about, it’s allowed under the law.”

While this is not binding guidance issued by the IRS, it seems unlikely Mr. Kieffer would have felt comfortable making such a statement blessing the technique unless, in fact, the IRS has determined the agency is not planning to challenge such arrangements.

[1] Stephanie Cummings, “IRS Won’t Target ‘Backdoor’ Roth IRA Contributions”, Tax Notes Today, July 11, 2018, 2018 TNT 133-2

[2] IRC §408A(c)(3), Reg. §1.408A-3, Q&A 3(b) and Notice 2017-64