Two-Step Roth IRA Conversions & Considerations

Two-Step Roth IRAs

High-income taxpayers face restrictions on their ability to contribute to a Roth IRA.  In 2019 a single taxpayer with adjusted gross income (AGI) of at least $122,000 or a married couple filing jointly with AGI starting at $193,000 will have their ability to contribute to a Roth IRA begin to phase out.  By $137,000 and $203,000 respectively, singles and married couples entirely lose the ability to contribute to a Roth IRA. While these contribution limits pose a challenge for many higher earners’ ability to contribute towards a Roth IRA, it is important to note that there is no income limit on the ability to convert a Traditional IRA to a Roth IRA.  Therefore, through proper planning, Traditional IRA assets may be efficiently converted into Roth IRA assets. If managed appropriately, a taxpayer can effectively circumvent the income limitations by engaging in a two-step contribution and conversion process (Two-Step Roth IRA), also commonly referred to as a “Backdoor” Roth contribution. Methodically engaging in this strategy may generate significant tax savings over time.

Roth IRAs - The Basics

A Roth IRA is an account in which post-tax money is contributed (as cash) into a retirement savings vehicle specifically designated as a Roth IRA (not to be confused with a Traditional IRA).  The contributing taxpayer must have had enough earned income for the period of contribution to match their contribution amount.  Alternatively, the taxpayer can be attributed their spouse’s earned income to be able to contribute to their own Roth IRA. This may be necessary when one spouses does have earned income, but the other does not but would still benefit from making this contribution.  The contribution may be up to $6,000 for 2019 for a taxpayer age 50.  Those over 50 may make a $1,000 catch-up contribution for 2019.

The unique benefit to a Roth account is that the earnings within the account grow tax-free within the account and the eventual withdrawals from the account are entirely tax-free as well - if a qualifying distribution occurs. The ability to shield those earnings from taxes while in the account, and then avoid ever having to pay tax on the ultimate distributions is a unique benefit provided by Roth accounts. This can therefore be an attractive asset source and planning vehicle to build for certain individuals in the context of their broader financial plans. Having assets in a Roth IRA and a diversified tax source of assets from which to distribute from later in life is an attractive reason in itself to consider a Roth IRA for those that can afford to do so. This article does not go into the specific rules concerning qualifying distributions, time constraints around conversions and ultimate withdrawals or exceptions and anyone who either has a Roth IRA or may be interested in establishing one, should be sure to check with their tax or financial advisor before engaging in any Roth strategies to ensure it fits within their plan.

Two-Step Roth - Step 1

The first step in safely performing a two-step Roth conversion is to create a Traditional IRA and a Roth IRA, assuming these accounts do not already exist.  Upon creation of the accounts, the taxpayer can make a contribution (up to the annual limit, not to exceed earned income) into the Traditional IRA. Traditional IRAs can always accept contributions (up to the IRS limits) if a taxpayer or their spouse has earned income and they are beneath age 70½.  Thus, a two-step Roth conversion is possible for many taxpayers with qualifying earned income.

A key factor to Step 1 however is that the contributing taxpayer does not receive an income tax deduction for this contribution. This is counter to many typical Traditional IRA contributions which may be eligible for a current income tax deduction equal to all (or a portion) of the contribution amount. The reason for why this is important will become apparent further within this article. 

Two-Step Roth - Step 2

Once the Traditional IRA has been funded with non-deductible contributions the conversion can occur. Assuming both accounts (Traditional IRA and Roth IRA) are at the same custodian, the process is as simple of coordinating a conversion of the account from the Traditional IRA into the Roth IRA. These assets can now grow income-tax free and be eligible for future tax-free distributions. This process can be systematically repeated over time to accumulate a significant figure within a Roth account.  If this is the strategy, it can make sense to keep the traditional IRA open, only using it ever as a conduit for Roth conversions.

An Example

Over time, consistent implementation of this strategy can make a material impact on overall wealth.  Let’s look at an example.  Assume that Joe Taxpayer is a high-earner and starting at age 30 begins implementing a two-step Roth strategy for the duration of his working years (through age 65) and taking advantage of catch-up contributions starting at age 50.  Joe invests at an annualized total rate of return of 7% during this time.  Assume that Joe’s brother, Jim Taxpayer invests the same amounts at the same times in the same investments as his brother over the same period of time, but does so through a normal taxable brokerage investment account.

Roth vs Taxable Investing over 35 Years.PNG

After age 65, Joe will have accumulated nearly $986,000 in his Roth IRA while Jim will have accumulated approximately $830,000 in his taxable account.  The difference is due to the impact of taxes over time on Jim’s account.  We assume nearly 2.5% of the annualized 7% return is attributable to dividend payments which are subject to a 30% combined tax rate for example purposes.  Further, we project a tax basis of roughly $370,000 for the $830,000 Jim has accumulated. This $460,000 difference will be subject to capital gains and potentially net investment income taxes when Jim has to liquidate his investments to use the funds. If this $460,000 is subjected a 30% combined rate, the tax cost is approximately $138,000.  All in, based on these assumptions Joe will have $986,000 of value by age 66 to do with as he wishes.  Jim’s all-in after-tax value is approximately $692,000.  This is a total difference of $294,000! An annual average difference of over $8,000 in savings by diligently following this strategy. If the rate of return were greater, the savings would be larger as well.

Important Considerations

So what’s the catch? The implementation of this strategy must be done carefully not to abuse IRS rules and applicable tax law. Further, there may be other, better options to access or accumulate Roth assets. Below are some important considerations to account for prior to implementing this strategy.

Understand the IRA Aggregation Rule prior to Implementation

A critical factor that must be considered before engaging in a two-step Roth strategy is whether the taxpayer has any preexisting Traditional IRAs.  If the taxpayer has a preexisting IRA they run the risk of incurring unintended income tax consequences as a result of IRC §408(d)(2) aggregation rules.  This rule requires a taxpayer who has multiple IRAs to aggregate them together as if they were one when a distribution is made out of any single IRA they have.  A conversion from a Traditional IRA to a Roth IRA is considered to be a distribution from one account into another.  Further, distributions out of an IRA are treated on a pro-rata basis to determine taxability.  As a result of the aggregation and pro-rata rule it becomes impossible to only convert the nondeductible contributions into a Roth IRA if the taxpayer has more than one IRA. Basically - you can’t pick and choose which dollars get converted.

For example, if Joe Taxpayer has a Traditional IRA worth $94,000 and separately funds a new Traditional IRA with $6,000 of nondeductible contributions.  If Joe converts the $6,000 to a Roth IRA, $5,460 of the conversion will be taxable income to Joe (94% of the conversion), while only $540 would be nontaxable (6% of the conversion).  This outcome defeats the very reason to do a two-step Roth in the first place!

All is not lost however if a taxpayer already has Traditional IRAs in place.  If a taxpayer is married, the aggregation rule is applied separately to each of them.  If the spouse does not already have tax-deferred IRA contributions within a Traditional IRA account, the household may still be able to implement the Two-Step Roth strategy. Further, some workplace plans such as 401(k)s allow participants to roll outside IRA assets into the plan.  If this opportunity exists, a taxpayer can take their pre-tax IRA contributions from any Traditional IRAs and roll them into a 401(k) while leaving the nondeductible contributions in the IRA.  This alone is typically not a reason to roll an IRA into a 401(k) if permitted, but doing so does make the taxpayer eligible for conversion and avoids concerns related to the aggregation or pro-rata rule, and as such should be considered.

Remember the conversion itself is a taxable event. Assuming the Traditional IRA assets have no earnings in excess of the contribution amount, the conversion of entirely after-tax dollars is deemed to be a return of principal with no income tax consequences - which is typically the ideal outcome and why understanding the aggregation rule is critical.  Once assets have been converted into the Roth IRA, the assets can be invested within the Roth account and grow completely tax free. 

Beware of Step-Transactions

The next hurdle to consider is to avoid engaging in what the IRS may consider a step-transaction.  A 1935 court case stipulated that a seemingly separate set of transactions that had no legitimate reason to be separate could indeed be treated by the IRS as one single tax event.  The risk here is that the IRS could rule that your separate contribution and conversion activities were truly intended to circumvent the laws in place intended to limit Roth IRA access for higher-earners.  As a result, a taxpayer would have to remove the funds from the Roth account and be subject to a 6% excise tax and a large headache, in addition to being put on the IRS’ radar.

It is important to note that all steps involved in a two-step Roth IRA are permissible, it is the pace and frequency at which they occur which can cause the IRS to frown upon this strategy. To avoid raising any unnecessary red flags with the IRS the most important factor is intent. If the IRS is able to prove that the intent of the two transactions in completing a two-step Roth conversion were done in an attempt to get around existing law, it can be a problem for the taxpayer.  If they are unable to prove that purely abusing the spirit of the existing law was not the intent, the transaction is allowed.  The best way to prove to the IRS that the intent was not to abuse the law is to separate contribution and conversion with an acceptable amount of time. 

The troubling part is how much time is enough time?  There are varying opinions on the matter, however a conservative rule of thumb is to have the contribution and conversion occur in separate tax years – at a minimum.  Some argue that waiting until the next statement cycle (typically one month) is acceptable.  Waiting over 12 months is even better if possible.  For example, a contribution in Jan of year 1, could be converted in Feb of year 2 at the same time an additional contribution is made into the Traditional IRA.  This process can be systematically repeated each year.

Roth 401(k) Solutions

Many taxpayers participate in a 401(k) plan through their employer.  Over recent years, an increasing number of 401(k) plans permit Roth 401(k) contributions that are made with after-tax contributions.  This is often the ideal solution for those that have it available to them.  With a Roth 401(k) a taxpayer can contribute an even greater figure than with a Roth IRA ($19,000 vs $6,000 in 2019).  With no income restrictions as with an IRA, a Roth 401(k) – if available – is an even better solution for those that can afford to make the contributions. Depending on a client’s tax rate and overall financial plan, this may be a more attractive approach than the Two-Step Roth approach. In some instances, perhaps making use of a portion of their 401(k) in a traditional manner, while still utilizing $6,000 of Roth 401(k) contributions (to achieve the same result) is the appropriate approach.

Have a qualified advisory team of tax and financial professionals in place

To ensure this strategy is properly implemented, monitored and reported it is important to coordinate these efforts with an advisory team proficient in both tax and investment planning. The value that can be captured through strategic implementation of a Roth IRA strategy can be significant over time.  Before engaging in this or any other tax, investment or financial strategies, please be sure to consult your team of qualified advisory professionals.

If you are interested in learning more about putting together a plan to take advantage of specific opportunities such as a Two-Step Roth plan and building it into a more comprehensive wealth management approach, we encourage you to contact us.

Disclosure: Hudson Oak Wealth Advisory LLC (“Hudson Oak” or “Hudson Oak Wealth”) is a registered investment adviser in the State of New Jersey & New York. For information pertaining to Hudson Oak’s registration status, its fees and services and/or a copy of our Form ADV disclosure statement, please contact Hudson Oak. A full description of the firm’s business operations and service offerings is contained in Part 2A of Form ADV. Please read this Part 2A carefully before you invest. This article contains content that is not suitable for everyone and is limited to the dissemination of general information pertaining to Hudson Oak’s Wealth Advisory & Management, Financial Planning and Investment services. Past performance is no guarantee of future results, and there is no guarantee that the views and opinions expressed in this presentation will come to pass. Investments involve risks and may lose value. Figures displayed within this communication are for illustrative purposes only. Nothing contained herein should be interpreted as legal, tax or accounting advice nor should it be construed as personalized Wealth Advisory & Management, Financial Planning, Tax, Investing, or other advice. For legal, tax and accounting-related matters, we recommend that you seek the advice of a qualified attorney or accountant. This article is not a substitute for personalized planning from Hudson Oak. The content is current only as of the date on which this article was written. The statements and opinions expressed are subject to change without notice based on changes in the law and other conditions.