Q&A: Here’s a retirement tax trick: the mega backdoor Roth IRA

Dear Liz: I am a 32-year-old married father of two. My income is high enough to contribute to my kids’ 529 and custodial brokerage accounts. I’ve been able to max out my 401(k), health savings account and backdoor Roths for my spouse and myself. Next, I’m debating between starting a life insurance retirement plan (LIRP) or making after-tax 401(k) contributions because my plan allows mega backdoor Roth conversions. What are your thoughts on LIRP versus mega backdoor Roth?

Answer: Mega backdoor Roths are such a sweet deal for higher-income workers that you probably should take advantage if you want to put aside more tax-advantaged money for retirement.

For those who are unfamiliar: Roth IRAs allow tax-free withdrawals in retirement, but only people with incomes under certain limits can contribute directly to a Roth. The ability to contribute phases out for married couples filing jointly with modified adjusted gross incomes of $204,000 to $214,000.

There’s no income limit on conversions, however, so people with higher incomes can contribute to a traditional IRA and then convert the contribution to a Roth IRA in what’s known as a backdoor Roth. Conversions typically trigger income taxes on any pretax contributions or earnings, so this tactic works best if the person doesn’t have a large existing IRA.

The mega backdoor Roth takes this strategy to a new level.

Some employer 401(k) plans allow participants to make after-tax contributions that can then be converted to a Roth. The amounts that can be contributed and converted are substantial. Although the pretax limit for contributions is $20,500 for workers under 50 in 2022, the total amount that can be contributed by employees and employers to a 401(k) is $61,000.

The amount you can put in after tax would be reduced by any company match you get. Assuming there’s no match, you could contribute $20,500 to the pretax plan and an additional $40,500 to the after-tax plan this year.

A mega backdoor Roth would allow you to build up a substantial fund of tax-free retirement money without the costs and other potential disadvantages of a LIRP, which requires you to buy a permanent life insurance policy. With a LIRP, you would use the cash value of the policy to hold investments that you could access tax free through withdrawals or loans.

LIRPs can make sense if you otherwise need permanent life insurance, but many people need only term insurance, which is much less expensive.

If you’re still interested in a LIRP, consult with a fee-only, fiduciary financial advisor first to ensure you understand how these work and determine if they’re a good solution for you.

Tuesday’s need-to-know money news

Today’s top story: Home Down payment – more attainable than you may think. Also in the news: The best balance transfer credit cards for business, the SmartMoney podcast tackles converting an IRA to a Roth, and how to avoid higher airline baggage fees.

Home Down Payment: More Attainable Than You May Think
Big down payments don’t have to be an obstacle.

Best Balance Transfer Credit Cards for Business
Three great options.

SmartMoney Podcast: ‘Should I Convert My IRA to a Roth?’
How to decide if and when to convert.

To Avoid Higher Airline Baggage Fees, Plan Ahead
Pay online to pay less.

Q&A: Retirement can bring some complex tax questions

Dear Liz: I was in the twilight of my career when the Roth became available, and I contributed the maximum for those few years before retirement. After retirement, I dropped to the 15% tax bracket, so I did Roth conversions of my regular IRA to fill out that tax bracket until I was age 70½. My reasoning was that I would likely be in the 25% tax bracket when I started my required minimum distributions from my IRA, and that turned out to be true.

The scary part is that the tax-deferred money in the rollover IRA has continued to increase each year in total in spite of the required minimum distributions. My tax preparer says he has clients who would be happy with my problem, so I should tread softly with my tax complaints.

One thing I regret is funding a nondeductible IRA for a few years before the availability of the Roth IRA. The nondeductible contributions only represent about 1% of the total. That means I can’t access that money I have already paid taxes on unless I have depleted all of my tax-deferred monies. Do you have any suggestions?

Answer: Absolutely. Listen to your tax preparer. Most retirees would love to have these problems-that-aren’t-really-problems.

You were smart to “fill out” your tax bracket by converting portions of your IRAs. For those who aren’t familiar with the concept, it involves converting just enough from an IRA to make up the difference between someone’s taxable income and the top of his or her tax bracket.

The top of the 15% bracket is $75,900 in 2017, so a married couple with a $50,000 taxable income, for example, would convert $25,900 of their IRAs to Roths. They would pay a 15% tax on the amount converted (plus any state and local taxes), but the Roth would grow tax-free from then on and no minimum distributions would be required.

These conversions can be a great idea if people suspect they’ll be in a higher tax bracket in retirement.

Now on to your complaint about getting back the already taxed contributions to your regular IRA. Withdrawals from regular IRAs are taxed proportionately.

The amount of your after-tax contributions is compared to the total of all your IRAs, and a proportionate amount escapes tax. So if nondeductible contributions represent 1% of the total, you’ll pay tax on 99% of the withdrawal. You’re accessing a tiny bit of your after-tax contributions with each withdrawal.

If you don’t manage to withdraw all the money, that’s not the worst thing in the world. It means you didn’t outlive your funds. Your heirs will inherit your tax basis so they’ll access whatever you couldn’t.

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

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.

How to start Roth IRAs for your kids

Dear Liz: I would like to start a Roth account for each of my kids. (They’re in their 30s.) Is it better to start an account in my name with them as beneficiaries or to start the accounts in their names?

Answer: Roth IRAs can be a wonderful way to save, but they’re not custodial accounts. You won’t be able to control the accounts or prevent your adult children from spending any money you deposit.

If you still want to help, though, let your kids know you’ll contribute to any Roths they set up. They can open a Roth if they have earned income at least equal to the annual contribution and their incomes are below the Roth limits. The ability to contribute to a Roth phases out between $178,000 to $188,000 for married couples in 2013 and from $112,000 to $127,000 for singles.

Ideally, you’ll contribute to your own Roth first. The limit on contributions is $5,500 this year.