Just like you, I have been seeing more and more articles on Roth conversions using terms such as “Backdoor Roths” or “Mega Roths.” The concept is neither new nor, until recently, particularly controversial. What’s changed are reports that several wealthy individuals have contributed stock into their Roth IRA from start-ups that have rapidly increased in value over time—and now look to produce tens of millions of dollars or more that will not be subject to tax when ultimately distributed. That’s not likely to be the situation for most of your clients—but the headlines will, and perhaps already have, generated interest.
Why it Matters
Individuals who expect to pay higher tax rates in the future may well want to pay taxes on their pre-tax savings (and earnings) now—and they may also want the flexibility to avoid the forced distribution (and taxation) of required minimum distributions. (Roths aren’t subject to those.)
The thing that makes Roth contributions unique is that they are made with after-tax dollars, but once held in that account (subject to certain restrictions[1]), the earnings that accumulate are not subject to tax, nor are the contributions (which were made with after-tax money). Note that while there are income limits to who can make a Roth contribution to an IRA, those do not apply to Roth 401(k) or Roth 403(b) accounts. However, the plan must allow Roth contributions (and not all do).
Conversions of pre-tax IRAs to a Roth IRA are allowable, though the entire amount would be taxable in the year converted. Many employer plans also allow for a conversion but again, it depends on the terms of the plan.
MEGA or Backdoor Roth Contributions
In a qualified plan that allows for after-tax employee contributions (again, this must be a provision in the plan), a participant may contribute the difference between their overall contribution limit ($58,000 for 2021 or $64,500 for those participants age 50 or older). For example, if a participant who is age 45 has deferred $19,500 and received $19,500 in match (and no other employer contributions or forfeiture allocations) decides to fund after-tax contributions, they may do so up to $19,000 ($58,000 – $19,500 – $19,500). Then if the plan allows for Roth conversions, they can covert the amount to a Roth. If the plan does not allow for Roth conversion, the participant may take a distribution and roll it to a Roth IRA.
So What Could Possible Go Wrong?
What is often forgotten is that working with retirement plans is never quite that easy. Here are a couple of items to consider:
- Roth contributions or conversions are taxable in the year contributed or converted. This may prove quite a shock at tax filing time if there is no withholding or planning on the amounts.
- Each Roth conversion has a separate five-year tracking period in order to be a qualified distribution so this may prove a challenge when record keeping the amounts. Basically, you’ll pay the taxes now, but would have to wait five years from the conversion for the Roth treatment to qualify. If you take distribution of the amounts before they are qualified for tax free distribution, then the earnings will be taxable and perhaps subject to the additional 10% tax under Code Section 72(t) (if you’re under age 59½).
- After-tax contributions to a qualified plan like a 401(k) are subject to the ACP nondiscrimination test (even in a safe harbor plan). Therefore a highly compensated individual who thinks they are utilizing the strategy may find that the conversion fails that test, and has to have that refunded.
- We recently received a question about a test that failed but was run after the amount was distributed and rolled to a Roth IRA. In that case the rollover would be ineligible and have to be disgorged from the account. (Personally, this is not a conversation I would want to have with the participant.)
- Of course, if the individual’s tax rate turns out to be lower in the future, then the tax benefit of this strategy may be lost.
Is it Worth it?
In summary, the Roth strategy may be right for you and your clients—but be sure that they’re aware—or beware—of all the potential tax implications.
Robert M. Kaplan, CFP, CPC, QPA, QKC, QKA, is the Director of Technical Education at the American Retirement Association.
Footnote
[1] Those conditions being that the account has been open for five calendar years and the distribution is after attainment of age 59½ or the death or disability of the accountholder.
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Sorry for the confusion but this area is a little tricky.
The first thing to note is that you are not prohibited from withdrawing a conversion but rather the tax implications are what are affected.
Each Roth conversion has its own 5-year counting period for purposes of the 10% early withdrawal additional tax under §72(t).
So if the account has been a Roth for five years and the individual is over the age of 59½ then there is no 10% tax.
If the individual is less than 59 ½ years of age, then the conversions that were made less than 5 years in the past would be subject to the 10% excise tax.
Hope this helps and please let me know if you have any additional questions.
--Bob Kaplan
Could you please clarify, as I've received conflicting information regarding your statement:
"Each Roth conversion has a separate five-year tracking period in order to be a qualified distribution so this may prove a challenge when record keeping the amounts. Basically, you’ll pay the taxes now, but would have to wait five years from the conversion for the Roth treatment to qualify"
My understanding is that the Roth IRA needs to be open for 5 years (and the client 59 1/2) prior to distributing funds that were converted. But - not that one has to wait 5 years for each conversion.
Here's my scenario that I'd like clarification on: A client with a Roth IRA (held more than 5 years) and a Traditional 401k requests (on the 401k rollover paperwork) that funds be rolled over to the Roth IRA. Client plans on doing this annually and plans to pay taxes out of pocket, and the ER 401k plan sends a 1099 with the taxable amount. Are you saying the client does not have access on each rollover for 5 years? Or do they have access since the Roth IRA has been open for more than 5 years?