Ask Matt: A New Twist on Roth IRA Conversions
In a new series, retirement and wealth strategies expert Matt Sommer answers questions from advisors on market events, legislation and trends that may impact their clients’ investments.
What is the difference between a “backdoor Roth IRA” and a “mega Roth” and how can my clients utilize them?
Both the backdoor Roth and mega Roth strategies may offer higher-income investors the opportunity to fund a Roth who might otherwise not be eligible. Let’s take the backdoor Roth first, as it is likely more familiar to readers. In 2018, only taxpayers with adjusted gross income less than $120,000 (single) and $189,000 (married filing jointly) may fully contribute to a Roth IRA, provided they or their spouses have earned income. One clever way around these income limitations is to fund a non-deductible IRA, then immediately convert the non-deductible IRA to a Roth IRA. Unlike Roth contributions, Roth conversions are not limited by income and since the converted amount consists only of a taxpayer’s basis (non-deductible, after-tax contributions) there are no resulting tax implications. The final result is a $5,500 contribution (or $6,500 if age 50 or older) to a Roth, regardless of a taxpayer’s income.
So, what is the catch and why don’t more taxpayers take advantage of this loophole? The answer lies in what is commonly referred to as the pro-rata rule. When a taxpayer takes a distribution from an IRA, a pro-rata portion of the distribution is considered pre-tax, assuming the taxpayer’s IRAs contain any after-tax dollars. For example, suppose a taxpayer has a $300,000 IRA rollover and attempts to do a backdoor Roth. Using the pro-rata rule, approximately 2% of the $5,500 conversion would be non-taxable, and 98% would be taxable. In short, all of a taxpayer’s IRAs must be considered under the pro-rata rule, making the backdoor Roth difficult for investors with existing rollovers and other substantial pre-tax IRAs.
The mega Roth applies to employer-sponsored salary deferral plans such as 401(k)s. Some, but not all, of these plans allow voluntary employee after-tax contributions. These contributions are in addition to the customary 402(g) limits of $18,500 ($24,500 if age 50 or older). Further, many plans allow employees to elect an in-plan Roth transfer. This transaction is the 401(k)-equivalent of a Roth IRA conversion. For instance, there are no income limitations and amounts transferred to the Roth are generally recognized as ordinary income. There is, however, one important distinction. The pro-rata rule does not apply with these Roth conversions and plans may allow employees the ability to pick which sub-accounts or buckets they wish to transfer to the plan’s Roth option.
Plans that permit voluntary after-tax contributions separately account for these contributions and associated earnings, and in-plan Roth transfers are set up to provide employees a mega Roth opportunity. In this case, the employee makes after-tax contributions and subsequently elects an in-plan transfer of these contributions and related earnings. Of course, if the transfer is done shortly after making the after-tax contributions, the earnings will be minimal.
Similar to the backdoor Roth, there is a catch to the mega Roth. 401(k) plans are subject to nondiscrimination tests to ensure the plan provides benefits to rank-and-file employees in addition to who the IRS deems “highly compensated” employees. The details of these tests are beyond the scope of this article, but plans that allow after-tax voluntary contributions are subject to a special nondiscrimination test (called an ACP test). Further, even those plans that are exempt from these tests because they make “safe harbor” company contributions must still pass an ACP test if voluntary after-tax employee contributions are permitted.
Depending upon the company and the demographics of its workforce, the ACP test might be too high of a hurdle and, therefore, companies may opt to pass on allowing voluntary after-tax contributions. Other companies may have to cap these contributions at a predetermined limit (in all likelihood, that limit will be greater than the $5,500 Roth IRA limit, hence the term mega Roth).
If these strategies sound complex, they are. Advisors are encouraged to work closely with their client’s tax advisors on the backdoor Roth and third party administrators (TPAs) and /or record keepers on the mega Roth.
2Source: Callan.com, 4/16/18
An IRA should be considered a long-term investment. IRAs generally have expenses and account fees, which may impact the value of the account. Non-qualified withdrawals may be subject to taxes and penalties. Maximum contributions are subject to eligibility requirements. For more detailed information about taxes, consult IRS Publication 590 or a tax advisor regarding personal circumstances.
Tax information contained herein is not intended or written to be used, and it cannot be used by taxpayers for the purposes of avoiding penalties that may be imposed on taxpayers. Such tax information and any estate planning information is general in nature, is provided for informational and educational purposes only, and should not be construed as legal or tax advice.