There are many tax planning strategies that allow financial advisors to demonstrate the ongoing value they provide to clients in exchange for the fees they charge. Part of this value is understanding the detailed nuances that make a strategy effective and implementing it correctly, avoiding issues with the IRS down the line. For instance, while backdoor Roth conversions are a well-known strategy, many individuals have either missed the opportunity to use it and/or implemented it incorrectly – which, left uncorrected, can result in unnecessary headaches, taxes, and even penalties – presenting an opportunity for advisors to add significant value for their clients.
The backdoor Roth strategy can be valuable for clients whose high income levels preclude them from making regular contributions to a Roth IRA. As while income phaseouts apply to contributions made to a Roth IRA, there are no such limitations on contributions made to a traditional IRA, nor on conversions from a traditional IRA to a Roth IRA (since 2010). Thus, the strategy itself consists of a 2-step process involving 1) a contribution (either deductible or non-deductible) made to a traditional IRA, followed by 2) conversion into a Roth IRA.
While this process might seem relatively straightforward, there are many reporting requirements for non-deductible IRAs (through IRS Form 8606) and numerous IRS rules around timing and accounting that can quickly turn this seemingly simple strategy into a literal lifetime of extra paperwork filing required of the taxpayer if completed incorrectly. For instance, if the client has existing IRA dollars and/or if they plan to rollover funds from a qualified account at any point during the year, backdoor Roth conversions can be complicated significantly. This is mainly because of the IRA Aggregation Rule, stipulating that when determining the tax consequences of an IRA distribution (which includes a conversion), the value of all IRA accounts will be aggregated together for the purpose of any tax calculations (turning a 'clean' backdoor Roth into a messy partial Roth conversion!).
To avoid this situation, before recommending a backdoor Roth, advisors need to make sure they know about every IRA dollar (everywhere in all accounts), review prior tax returns for Form 8606, and confirm that there will not be any rollovers during the remainder of the current year. For clients with a tax-free basis in an IRA, options to remove the taxable gain portion (and become eligible for a 'clean' backdoor Roth) include converting the balance to a Roth (which could be done over multiple years) or rolling the pre-tax funds into a company retirement plan or Solo 401(k) (though not a SIMPLE or SEP as they are lumped in with traditional IRAs for the pro-rata rule).
Advisors also can support the backdoor Roth process by communicating with clients' tax preparers about the strategy and why they are recommending it for their mutual client. Because while advisors might recognize the long-term benefits of having money in Roth accounts, the process does not come with a current-year benefit that may be immediately apparent to the tax preparer; furthermore, it requires tax preparers to complete additional forms (which they may not appreciate if they’ve not bought into the long-term 'why' themselves).
Ultimately, the key point is that while backdoor Roth conversions can be a valuable strategy, it comes with significant rules and nuances that, if not fully understood, have the potential to cause onerous tax complications for clients in the future. Which means that advisors can add significant value by working together with clients and their tax preparers to ensure that the backdoor RIA process is completed correctly!
