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TAX PRACTICE CORNER

Making a “backdoor” Roth IRA contribution

BY KIM T. MOLLBERG, CPA, CGMA, CMA, MBT

APRIL 2013

Sec. 408(d)(1) ordinarily requires a pro rata allocation between taxable andnontaxable amounts (using the Sec. 72 annuity rules) when reportingdistributions received from an individual retirement plan (an individualretirement account or annuity (IRA)). The practical effect is that a taxpayermust recover any nontaxable amount (basis) ratably as distributions arereceived, by tracking basis on Form 8606, Nondeductible IRAs. The taxliability on such a distribution can sometimes lead a taxpayer to improperlyconclude his or her best option is to recover the nontaxable portion ratably asdistributions are received, without considering a Roth conversion.

Taxpayers looking for tax benefits and flexibility should consider Sec. 408(d)(3)(A)(ii), which provides an important but sometimes overlooked exception tothe pro rata rule. It applies to certain distributions rolled over to an eligibleretirement plan (that is not an IRA). For this exception to apply, “the maximum

amount which may be paid into such plan may not exceed the portion of the amount received whichis includible in gross income (determined without regard to this paragraph).”

Put another way, if a taxpayer rolls over a distribution from his or her IRA to an eligible retirementplan (e.g., a Sec. 401(k) plan) for his or her own benefit, and the amount rolled over equals onlythe sum of deductible contributions and earnings on all contributions (whether earned on deductibleor nondeductible portions) but not any nondeductible contributions, the entire amount rolled overwill not be taxed at the time of rollover. Instead, that amount will be taxed as it is distributed fromthe Sec. 401(k) or other eligible plan under rules applicable to the particular plan. The taxpayer’sremaining IRA balance after the rollover should equal its basis, so the taxpayer could immediatelywithdraw that remaining balance tax free or convert it to a Roth IRA tax free.

Eligible retirement plans that can receive (but are not required to accept) rollovers from IRAsinclude qualified trusts (including Sec. 401(k) plans), Sec. 403(a) annuity plans, Sec. 403(b)annuity contracts, and Sec. 457(b) plans (that meet certain requirements). Taxpayers withnontaxable amounts sitting in an old employer’s eligible retirement plan might consider first rollingover the old plan to an IRA, then transferring the taxable amounts from the IRA to the newemployer’s eligible retirement plan.

A taxpayer might not have an eligible retirement plan to which taxable amounts can be rolled. Inthat case, self-employed persons, corporations, or partnerships could set up Sec. 401(k) plans,

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which represents nondeductible contributions; a $10,000 balance in a SIMPLE IRA, none of whichrepresents nondeductible contributions (assume she has been a participant for more than twoyears); and a $100,000 balance in a Sec. 401(k) plan at her current employer, of which $1,000represents nondeductible contributions. Assume the Sec. 401(k) plan of an old employer, whichpermitted after-tax contributions by employees, was previously rolled over to her traditional IRA,thus creating the $27,000 basis. Assume her current Sec. 401(k) plan permits after-taxcontributions by employees and will accept rollovers from her traditional IRA, SEP-IRA, andSIMPLE IRA, and Cheryl is willing to accept the investment prospects offered by the plan. She isalready making the maximum current-year Sec. 401(k) contribution and would like to benefit from aRoth IRA, if possible.

In light of this, Cheryl should consider what practitioners refer to as a “backdoor” Roth IRAcontribution. First, Cheryl would make a $5,000 nondeductible contribution to her traditional IRA.The amount, equal to the maximum annual Roth IRA contribution she would not otherwise beeligible to make because of her income level, also creates additional basis.

Second, she would roll over (within 60 days, unless a hardship exception applied) to her currentSec. 401(k) plan everything in her IRAs except an amount equal to her $32,000 basis in theaccounts. The distribution would qualify because it would not be a required minimum distribution.Sec. 408(d)(3)(G), which states a distribution from a SIMPLE IRA during the first two years ofparticipation can be rolled over only to another SIMPLE IRA, would not apply.

Under the rules of Sec. 408(d)(3)(H), the rollover in step two above could consist of anycombination totaling $53,000 (for example, $53,000 of her $55,000 traditional IRA balance),leaving basis of $32,000 in her IRAs (in this example, $2,000 in her traditional IRA, $20,000 in herSEP-IRA, and $10,000 in her SIMPLE IRA). None of the $53,000 in rollovers would be taxable atthe time of the rollovers.

Third, she would convert the $32,000 remaining in her IRAs to a Roth IRA. Note that the $99,000future taxable amount in the Sec. 401(k) plan immediately before the conversion would not factorinto the pro rata calculation because the Sec. 401(k) plan is not an IRA.

After everything was done, Cheryl would be set up so that in future years she could make annualnondeductible contributions to her traditional IRA followed by annual conversions to her Roth IRA,with few, if any, tax consequences.

By Kim T. Mollberg, CPA, CGMA, CMA, MBT, (mollberg@mnstate.edu) an assistant professor

of accounting at Minnesota State University Moorhead, Moorhead, Minn.

To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior

editor, at pbonner@aicpa.org or 919-402-4434.

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Making a “backdoor” Roth IRA contribution http://www.journalofaccountancy.com/Issues/2013/Apr/20126284.htm

2 of 2 3/25/2014 6:53 PM