3rdPartyFeeds News

TaxWatch: Here’s why you may want to reconsider doing that backdoor Roth IRA conversion

Plenty of potential pitfalls and booby traps.

Converting taxable income into nontaxable income is something all taxpayers are eager to do. The backdoor Roth IRA is one of those options — but there are state and federal tax pitfalls to converting money from a traditional IRA or a qualified retirement account (such as a 401(k)) to a Roth IRA.

Taxpayers cannot make any contribution to a Roth IRA if their income exceeds the annually adjusted threshold limits. For 2019, the threshold levels are $203,000 for married filing jointly, $10,000 (no, this is not a typo) for married filing separately, and $137,000 for all other taxpayers. The threshold limits for making a tax-deductible contribution to an IRA in 2019 are $123,000 for married filing jointly, $10,000 for married filing separately, and $74,000 for all other taxpayers.

However, there are no limits for making a nondeductible contribution to an IRA, so some suggest putting money in an IRA and then converting it to a Roth IRA in what’s known as a backdoor Roth IRA.

What’s the appeal of moving money from a traditional IRA to a Roth IRA? In a traditional IRA, contributions may be tax-deductible, but withdrawals are taxed as income. In a Roth IRA, contributions are made with after-tax money, but withdrawals are tax-free. In both cases, earnings grow tax-free, and penalty-free withdrawals are allowed beginning at age 59 ½.

Now, a true backdoor Roth IRA transaction is one where a taxpayer doesn’t have an IRA and can’t contribute to a Roth IRA. In this case, the taxpayer makes a nondeductible contribution to a newly created IRA and then converts those funds into the Roth IRA after a few weeks pass. If the rollover is done too soon, the two transactions could be viewed as one transaction, which would result in an excess contribution to the Roth IRA.

Pitfall 1: In many cases, a taxpayer already has an IRA, funded with previously deducted or non-deducted contributions or a combination. The taxpayer then must determine what share of the amount being converted is taxable and how much is nontaxable. The nontaxable portion includes the nondeductible contribution. And by making a nondeductible contribution, the taxpayer now must do the calculation.

For example, taxpayer A has $45,000 in an IRA and makes a $5,000 nondeductible contribution to the same IRA, which gives it a balance of $50,000. If Taxpayer A withdraws $5,000 from the IRA and rolls it into a Roth, $500 would be nontaxable ($5,000/$50,000) x $5,000 withdrawn as part of a conversion) but $4,500 would be taxable ($5,000-$500) at her marginal tax rate on that year’s return.

It doesn’t matter if a taxpayer has one or more IRAs when calculating the nontaxable amount from the withdrawal [(total nondeductible amount / total IRA value) x total amount withdrawn]; they are treated as a single IRA.

Is there a way around the existing IRA dilemma? Yes, Taxpayer A above could make the same $5,000 nondeductible contribution to the existing IRA and then do a rollover of the entire IRA amount whereby the $5,000 nondeductible amount is rolled over to the Roth IRA and the $45,000 taxable amount is rolled over to a new IRA. And no taxes are owed for this transaction on that year’s return.

The 10% additional tax for an early distribution from an IRA doesn’t apply if the conversion is completed within 60 days through a rollover.

Read: The Roth strategy we wish we’d built for early retirement

Pitfall 2: The timing of a conversion to a Roth can have hidden costs. If a taxpayer makes the conversion within a year or two of retirement or after beginning to collect Social Security benefits, the added income from the conversion can easily increase the cost for Medicare part B for both the taxpayer and spouse’s Medicare Part B cost. Remember, this cost is determined on the income attributable to two years earlier (i.e., 2019 income determines the Part B cost for 2021).

Pitfall 3: State income taxes can be complicated. Most states with income tax laws treat the conversion in the same manner as the federal income tax laws. So whatever is included in federal income is likewise included in state income. But some states will exempt some part of a pension or IRA distribution from taxes if the person is over a certain age, which varies by states. For example, some amount of an IRA distribution is tax-free in South Carolina and Wisconsin for those who are age 65, in Delaware starting at 60, and in Colorado starting at 55.

Among other states, Pennsylvania and Illinois exclude the entire conversion amount from tax, and states without an income tax law also don’t tax any conversion amounts. So those taxpayers are only subject to the federal income tax on the conversions.

But rules in other states can be a giant headache. New Jersey and Massachusetts don’t allow a taxpayer to deduct contributions to an IRA even if the contribution is deductible for federal income taxes. So these taxpayers must determine not only their taxable and nontaxable portion for their federal tax return but also must separately determine their taxable and nontaxable portion for their state tax return, which is different.

Doing a conversion in a year that a taxpayer moves to another state can create another tax situation for the taxpayer. Oregon requires the entire taxable amount of the Roth conversion to be included in state gross income if the taxpayer is a resident of Oregon at the time of the conversion. Iowa, on the other hand, requires a taxpayer to include in state gross income the portion of the taxable amount attributable to the months of their residency in the state – and stipulates that a month is determined if the taxpayer spends 16 or more days (15 days for February) in Iowa.

Read: Why new tax rules make Roth accounts better than ever

Pitfall 4: Don’t forget to calculate the payback period for a conversion. A taxpayer in the 35% federal income tax bracket who converts $12,000 into a Roth incurs $4,200 in federal taxes. To just earn enough to cover those taxes, the remaining $7,800 would need nearly 18 years at a 2% return and nearly 5 years at an 8% return. Of course, the distribution from the Roth IRA will be tax-free after reaching age 59 ½, and you may live another 20 or 30 years from then.

In summary, backdoor Roth IRAs or converted Roth IRAs should not be rushed into without adequate thought and planning. Each person’s federal and state income-tax-rate situation and investment strategy is different. So seek qualified tax advice before moving funds from an IRA to a Roth IRA. Otherwise you may be in for a federal or state income-tax surprise.

Anthony P. Curatola is the Joseph F. Ford Professor of Accounting at Drexel University’s LeBow College of Business and editor of the Taxes column for Strategic Finance.

Read More

Add Comment

Click here to post a comment