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As a part of the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), income limits on Roth conversions were repealed, starting in 2010.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}.)
