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Roth conversions

Q&A: When it comes to Roth IRAs, 59½ and 5 are the magic numbers

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Dear Liz: You recently answered a question about Roth conversions, saying that each conversion triggered its own five-year holding period. It was my understanding that after age 59½, the five-year rule doesn’t apply and earnings aren’t taxed.

Answer: The rules for Roth IRAs can be complicated, and they’re different for accounts that you fund directly versus those that are funded through conversions.

If you contribute directly to a Roth, you can withdraw your contributions any time without tax or penalty. You can withdraw earnings tax free if you’re 59½ or older and the account has been open for at least five years.

But as mentioned in the previous column, the five-year holding period applies to each conversion you make from another retirement account into a Roth. What goes away after age 59½ is the 10% penalty for early withdrawal, says Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting. Earnings withdrawn before five years can be taxed as income. However, it’s assumed that any withdrawals are principal first, so you’d have to withdraw the entire conversion amount before earnings would be taxed.

Luscombe notes that some people set up separate accounts for each conversion to make tracking the five-year periods easier. That could be especially helpful if they plan to make substantial withdrawals that could include earnings before the last conversion amount hits its five-year mark. Once all the five-year periods have expired, the accounts can be combined into one.

How long will “back door” Roth conversions be allowed?

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DoorWealthier taxpayers are doing a two-step around Roth income limits by putting money into regular IRAs and then promptly converting the accounts to Roths.

They’re taking advantage of Congress’ decision to remove the previous $100,000 income limit for conversions. That decision, which took effect in 2010, led to a conversion boom: $64.8 billion transferred from regular IRAs to Roths that year, compared to $6.8 billion the year before.

The rich know a good deal when they see one: more than 10% of those earning $1 million or more converted to a Roth in 2010, Bloomberg reported.

Moving money from a regular IRA to a Roth usually requires paying income taxes, but the converted money gets to grow tax-free from then on. Roths also don’t have minimum distribution requirements, so the money can be passed free of income taxes to heirs.

Removing the $100,000 income limit for conversions also opened the door for what’s known as a “back door” Roth contribution.

Your ability to contribute directly to a Roth phrases out with if you’re single and your modified adjusted gross income is between $114,000 and $129,000 in 2014. For married couples filing jointly, the phase out range is $181,000 to $191,000.

People whose incomes are too high to contribute directly to a Roth can get around those limits, however, by contributing to a regular IRA and then converting that money to a Roth. The conversion can happen essentially tax-free if you don’t already have money in an IRA and you convert the money soon after contributing it.

If you already have a fat IRA account, such a conversion can trigger a tax bill, since you have to include all of your IRA assets when figuring the taxes on a conversion. The “pro rata” rule requires you to pay a proportional amount of taxes on the original account’s pretax contributions and earnings. If 90% of your IRA accounts are pretax contributions and earnings, then 90% of your conversion amount would be subject to tax. (Ever-helpful Bankrate.com has a conversion calculator to figure out whether paying the tax might be worthwhile.)

But there’s even a way around the pro rata rule, apparently. If your 401(k) allows you to “roll in” an IRA account, which some do, you can essentially make your existing IRA disappear from the conversion tax calculation.

None of this is exactly secret. This Vanguard video discusses how to do backdoor Roth contributions, as does this Wall Street Journal post, this post from MarketWatch and these piece from Forbes, among many others. This article from the Journal of Accountancy, the “flagship publication” of the American Institute of Certified Public Accountants, discusses the roll-in strategy for avoid the pro rata rule.

But some smart people, like financial planner Michael Kitces, have argued that there’s a risk to backdoor Roth conversions that’s not as well publicized: that IRS could step in at any time and invalidate the conversions, perhaps even imposing a 6% “excess contribution” tax on the money. “The IRS can still call a spade a spade,” Kitces wrote on his blog Nerd’s Eye View, “and the rising abuse of this ‘loophole’ may bring about its permanent end.”

“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,” Kitces wrote. “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.”

Other smart people, such as IRA expert Ed Slott, have argued that the “step transaction doctrine” that allows the IRS to unwind economically bogus transactions doesn’t apply in this case.

“My general advice to clients who cannot make contributions directly to a Roth IRA (due to high income) is to make the contribution to their IRA first, let it stay there for at least a day or two – so it shows up on at least one traditional IRA statement – and then convert it to a Roth IRA,” Slott wrote.

This is not a new discussion, by the way. You’ll note the blog posts above are a few years old. The IRS has yet to clear up the mystery.

My take: since the IRS hasn’t officially weighed in, there’s a risk involved in these transactions. High earners may feel the risk is well worth taking, given the huge benefits Roths offer.