Is the Backdoor Roth legal or not?

[mamster]

Michael Kitces says it's clearly contrary to the spirit of the law and the IRS could retroactively disallow it, resulting in years of overcontributions. I'm not sure what to think.

Dodging The Income Limits on Roth Contributions - Strategy Or Abuse?

The fact that the IRS hasn't done anything yet doesn't seem like a good argument--it sounds a lot like "my tech stocks haven't blown up...yet."

[bottlecap]

I think that it would be a highly unlikely thing for the IRS to do. I would think it would also be very difficult for them to track such transactions. Moreover, the net result would be almost nothing - taxes have already been paid on the nondeductible contributions, so it would cost the IRS a lot of manpower to enforce and recover little or no tax revenue - resulting in a huge net loss.

I wouldn't lose sleep over it.

JT

[Brody]

I agree with BottleCap. I could see them changing the loophole, but not going after people who have already done it. There is so little benefit to going after people.

Ex. Jim does it this year and the next 4 years. He has put in $20,000 and his account value is $23000. The IRS disallows what he has done.

If I'm not mistaken, if they did that, the contributions would revert to being a traditional non-deductible IRA. The IRS has not collected a penny of extra tax because his $3,000 gain would not have been taxable as of yet. They'll (The IRS) benefit many years into the future.

It would just be easier and cheaper to close the loophole.

[mikep]

I don't see how they could go back retroactively and demand penalties/interest/back taxes if what you did was legal at the time.

Probably the easiest way to fix it is to just disallow traditional IRA contributions for everyone unless they are deductible moving forward. This lets people still do conversions and give them tax revenue on previous traditional IRAs but closes the backdoor Roth loophole on new contributions. But shh, don't tell them about my idea.

[LH]

Well, the IRS knows it is going on.

The IRS has done nothing to stop it.

Why has the IRS not stopped it? It may like whatever revenue is generated by people converting past IRAs to ROTH IRAs and paying the taxes now. Initially, my wifes IRA to ROTH ira conversion involved us paying maybe 10K or so in taxes. Now the current backdoor conversion, is after tax, so no new taxes.

the end result is that the client annually completes the equivalent of a Roth contribution, neatly dodging the existing Roth contribution income limit while having no immediate tax impact (since the non-deductible IRA contribution has no tax consequences, nor does the Roth conversion of an IRA whose non-deductible contributions equal its current value).

To do this though, one has to have ZERO before tax IRA contributions, or it DOES have tax consequences. My wifes tax consequences, were manageable, so we converted her to a ROTH. My tax consequences would have been possibly in the 5 figures.... so no ROTH for me, and no backdoor ROTH either for me. Going forward, after the initial tax hit, the backdoor roth for the wife has no tax consequences now.

If the people know the IRS knows, and allows it to go on, then tries to retroactively stop it later, it would upset voters and therefore politicians (politicians may do it themselves directly too).

Its like the 401k, it started out as a loophole I believe, that some people were loath to use.

The tech stocks had not blown up yet, and then did, was a market decision. The market is the market, kinda like the weather, oh, the market crashed, well, yeah, the market crashed, who do you appeal to? Its like a hurricane came. File a complaint with who exactly? One cannot reverse a hurricane, nor market crash by appeal.

Verus the IRS. The IRS is a division of government, it is responsible for its decisions, it has appeals process both internally and to external courts, if problems are perceived to be large, has de facto legal appeals process to politicians. The could pass a law saying its ok, and reverse the IRS decision.

If the IRS reverses, it would likely just stop the current conversions going forward, not retroactively I would think?

How many IRS adminstrators do backdoor ROTH conversions themselves? How many politicians? How many voters? I have no clue. But I think all that would factor in.

Anything could certainly happen though. The government could reverse ROTH iras nontaxability in its entirety 20 years hence, and tax it.... Repeat the 1933 gold laws, etc.

Its an interesting issue.

n the end, the contribute-and-then-convert strategy is not expressly prohibited by the tax code, but the IRS does have the right to tax a transaction according to its true economic reality. And if the express goal and intent of the client is merely to circumvent the clear intent of the law, and is done in a manner that blatantly disregards it, beware. While the reality is that the likelihood of getting caught is extremely low, when the IRS believes that a transaction is abusive, not only do they act to shut it down, but they don't always provide leniency for those who have already tried to take advantage of it in the past.

Well here, the likelyhood of "getting caught" is extremely high. The IRS KNOWS people are doing this, in fact, I think as soon as the change was made, this stategy was talked about.

Well, here is evidence that the IRS does not believe the act is abusive.... if they believe its abusive, they act to shut it down......

To act to shut it down largely, all they would need to have done is make a statement, we believe that backdoor ROTHS are illegal. Heck, they could even make it "off record" to the financial press. Then the adventursome types might still do it, and people like me would not.

This is basically the same thing as the "wash rule" substantially identical or whatever the phraseology is. Never been ruled on per se that I know of yet. I guess they could deem it abusive, and then retroactively go back, and not be lenient retroactively with everyone who tax lost harvested using widely accepted practices. Seems unlikely. A sense of fairness, and good faith, is important for tax collections in general. Bad faith in aggregate practically works both ways.

[Brody]

I don't see how they could go back retroactively and demand penalties/interest/back taxes if what you did was legal at the time.

The step transaction doctrine stops the move from being legal at the time that it was done.

Because of the step transaction doctrine, every move that a person makes can be legal, but that doesn't make the entire transaction legal.

In short, this is how this could work.
1)A high income person puts money into a non-deductible IRA (Legal)
2)The non-deductible IRA gets converted to a Roth. (Legal)

Obviously both things are legal.
However, if the IRS says that the high income person put the money into a non-deductible IRA for the purpose of conversion to get around the Roth IRA income limits, they could call this an illegal step transaction.

Here's an example that I use with 529 plans.

Bob opens 100 529 plans each with a different beneficiary. Bob's dad funds each one with $50,000. Bob's dad just made 100 gifts to 100 different people with no tax ramifications. Bob immediately closes each account and invests the $5,000,000 with no taxes and no penalties.

Every step was legal. It is the step transaction doctrine that stops this.

[PreserveCapital]

OK.....

what happens if:

2012--starting with zero in any Roth or Traditional IRA accounts--

On 1/1/2012, taxpayer makes a non-deductible Tira contribution of 5000. Taxpayer bides time and does not do a Roth conversion in 2012.

Jan. 1, 2013--taxpayer converts to a Roth, the 5000 existing Tira balance.


(arbitrary length of time passes): April 1, 2013--taxpayer makes his 2013 non-deductible Tira contrib of 5000.

the next year, and all following years...Rinse, repeat....ad infinitum....

In the example I provided, the taxpayer is not literally "backdooring" the same year's Tira contrib. to the Roth. It's a different year's money, each time.

Even assuming the step transaction doctrine might be applicable, how would it be applicable to this scenario, if at all?

[LH]

I don't see how they could go back retroactively and demand penalties/interest/back taxes if what you did was legal at the time.

The step transaction doctrine stops the move from being legal at the time that it was done.

Because of the step transaction doctrine, every move that a person makes can be legal, but that doesn't make the entire transaction legal.

In short, this is how this could work.
1)A high income person puts money into a non-deductible IRA (Legal)
2)The non-deductible IRA gets converted to a Roth. (Legal)

Obviously both things are legal.
However, if the IRS says that the high income person put the money into a non-deductible IRA for the purpose of conversion to get around the Roth IRA income limits, they could call this an illegal step transaction.

Here's an example that I use with 529 plans.

Bob opens 100 529 plans each with a different beneficiary. Bob's dad funds each one with $50,000. Bob's dad just made 100 gifts to 100 different people with no tax ramifications. Bob immediately closes each account and invests the $5,000,000 with no taxes and no penalties.

Every step was legal. It is the step transaction doctrine that stops this.

Nice explanation of step transaction doctrine btw, thanks : )

If the above 529 plan was being done on a widespread basis, written about in newspapers, magazines, talked about on financial shows, and was open, known, widespread.....

What would the IRS do?

Would they allow it to sit there for a couple years, and then act?

I posit they would stop it quickly. Maybe not? Just seems to make sense there would be comments coming out that, uh, no, do not do that. Why allow it to percolate and be talked about then practiced widespread? Predation?

Back to the backdoor ROTH.
I would imagine already even, in audits ongoing this year, someone would have to have done a backdoor ROTH, if they disallowed it, would that not make news? Seems the window would be pretty small going forward? If they allow it to pass in audits, well... it is what it is right?

[SSSS]

Obviously it's legal at the present time.

Will the law be changed again in the future? Maybe, but you'd probably hear about it at least a year or two in advance.

Retroactive punishments for activity that was legal at the time would likely be declared unconstitutional under ex post facto doctrine.

If you're worried that they would do this to backdoor Roth conversions, why not worry that they would retroactively abolish ALL IRAs and 401k?

Also:

http://www.forbes.com/sites/ashleaebeli ... ent-kitty/

Ashlea Ebeling, Forbes Staff 1 day ago

I checked in with several IRA experts who all dismissed the possibility that the IRS would apply the step transaction doctrine (used to disallow corporate tax shelters) in the context of the backdoor Roth, as unlikely. Then I checked back in with Robert Keebler in Green Bay, Wisc., who suggests a 6-month waiting period between the time you contribute to a nondeductible IRA and convert to a Roth. But even he says: “I don’t see the IRS chasing this. The law allows you to do it.” The worst thing that could happen is that the IRS would say that the money has to go back into a nondeductible IRA, Keebler says, noting that if you’re doing this as a serial maneuver, you’ve run the 3-year statute of limitations on most transfers.

[555]

Some people haven't noticed that 6%>0% (and it's per year)! The IRS may do nothing, but theoretically they could wait twenty years and then just swipe your entire balance.

[natureexplorer]

Everything is possible, but there is (I believe) no precedent for retroactively increasing taxes, which is what this would be.

[ThePrune]

I've not yet seen anyone in this posting stream point out that the two routes of money flow (i.e. the direct contribution and the IRA Back-door conversion) do not end up with money in exactly the same state. This might impact the applicability of the Step Transaction doctrine.

Money contributed to a Roth IRA ends up in a state where it can be withdrawn at any time without a 10% penalty being owed.

Money converted to a Roth IRA ends up in a state where it is subjected to a 5 year delay before it can be withdrawn without a 10% penalty (unless the account owner is over age 59 1/2 and has a Roth account open for at least 5 years).

So its really not the case that the two paths (i.e. contribution and Back-door conversion) lead to exactly the same final condition. Close, but not identical.

[retiredjg]

It might be wise to remember that the IRS does not make laws. They collect money according to the laws enacted by Congress and sometimes there are unintended consequences that have to be worked out somehow. In this case, however, I believe Congress was probably aware of how this would work out - lots of tax money coming in, because of the pro-rata rule, at the end of the Bush tax cuts.

I simply do not believe the IRS would put a lot of time and money into trying to undo all this. It would tangle up the system and everything would come to a standstill. Can you imagine all the folks who would say "Well, I would not have converted all that tIRA I had at 35% if I had known this would happen! Give me that money back!"

In order to enforce a prohibition on the back door, some time limit would have to be placed on conversion money or conversions would have to be eliminated entirely. How in the heck could they keep up with all that? I think it would be unenforceable and the IRS is not in the business of trying to micromanage stuff that is unenforceable (although they already do have a nice list of stuff like that).

I just believe the IRS has more important things to do.

[retiredjg]

Money converted to a Roth IRA ends up in a state where it is subjected to a 5 year delay before it can be withdrawn without a 10% penalty (unless the account owner is over age 59 1/2 and has a Roth account open for at least 5 years).

This used to be a commonly held belief around here, but it appears it is not correct.

If the money is not taxed upon conversion (as is the case with a true back-door contribution to Roth IRA), apparently there is no 5 year rule and that money is treated just like an ordinary contribution (available any time).

I'll let Interplanetjanet and Alan S. explain cause I sure can't.

[ThePrune]

If the money is not taxed upon conversion (as is the case with a true back-door contribution to Roth IRA), apparently there is no 5 year rule and that money is treated just like an ordinary contribution (available any time).

I'll let Interplanetjanet and Alan S. explain cause I sure can't.

I'd definitely be interested in seeing how this would be argued based on the Internal Revenue Code or based on IRS Revenue rulings. I'm not being sarcastic, just want to see a solid argument.

[interplanetjanet]

If the money is not taxed upon conversion (as is the case with a true back-door contribution to Roth IRA), apparently there is no 5 year rule and that money is treated just like an ordinary contribution (available any time).

I'll let Interplanetjanet and Alan S. explain cause I sure can't.

I'd definitely be interested in seeing how this would be argued based on the Internal Revenue Code or based on IRS Revenue rulings. I'm not being sarcastic, just want to see a solid argument.

I can dig into the code again or Alan can (I'd have to look it back up), but:

It's the result you get from the IRS forms
It's in Pub. 590:

You generally must pay the 10% additional tax on any amount attributable to the part of the amount converted or rolled over (the conversion or rollover contribution) that you had to include in income (recapture amount).

Admittedly, the two situations are not *quite* identical - when you withdraw directly contributed money you are making a "return of contributions". With you withdraw money that was converted from a nondeductible-only IRA (no tax due) you are potentially making an unqualified distribution, albeit one with no penalty attached at all. Try the forms out.

Ordering rules do apply, and a for a conversion in a given year the dollars that had to have tax paid to get them into the Roth come out first - and 10% will be owed on those in an unqualified distribution. For a "backdoor only" Roth this is obviously not an issue.

-janet

[interplanetjanet]

Try the forms out.

Sorry if that was a little curt. The instructions for form 5329 make it reasonably clear - start with the "Distributions from Roth IRAs" section.

This does seem reasonably well known:

http://www.fairmark.com/rothira/distrib.htm

Treatment of Distributions

The tax treatment of the different categories of distributions may be summarized as follows:

Regular Contributions

* Can be withdrawn at any time with no tax and no penalty.
...
Nontaxable Portion of Any Rollover

Applies only after the taxable portion of the same conversion has been withdrawn.

* Can be withdrawn at any time with no tax and no penalty.

Clear as mud?

-janet

[LH]

1)

Money converted to a Roth IRA ends up in a state where it is subjected to a 5 year delay before it can be withdrawn without a 10% penalty (unless the account owner is over age 59 1/2 and has a Roth account open for at least 5 years).

2)

This used to be a commonly held belief around here, but it appears it is not correct.

If the money is not taxed upon conversion (as is the case with a true back-door contribution to Roth IRA), apparently there is no 5 year rule and that money is treated just like an ordinary contribution (available any time).

I'll let Interplanetjanet and Alan S. explain cause I sure can't.

I am sorry for being obtuse, but I have read interplanet janets reply, and I am still uncertain if statement 1) is true, or if statement 2) is true. Or if unknown?

thanks for clearing up,

LH

[ThePrune]

Ordering rules do apply, and a for a conversion in a given year the dollars that had to have tax paid to get them into the Roth come out first - and 10% will be owed on those in an unqualified distribution. For a "backdoor only" Roth this is obviously not an issue.

Thanks for responding. This prompted me to reexamine the instructions for Form 5329 (Additional Taxes on Qualified Plans (Including IRAs)
and Other Tax-Favored Accounts) and the rules for recapture amounts subject to additional tax on early distributions from Roth IRA conversions. I read the rules to say exactly what you indicated. The key is the amount of the conversion that was included as taxable income, which is $0 for a "perfect" back-door Roth conversion.

[interplanetjanet]

1)

Money converted to a Roth IRA ends up in a state where it is subjected to a 5 year delay before it can be withdrawn without a 10% penalty (unless the account owner is over age 59 1/2 and has a Roth account open for at least 5 years).

2)

This used to be a commonly held belief around here, but it appears it is not correct.

If the money is not taxed upon conversion (as is the case with a true back-door contribution to Roth IRA), apparently there is no 5 year rule and that money is treated just like an ordinary contribution (available any time).

I'll let Interplanetjanet and Alan S. explain cause I sure can't.

I am sorry for being obtuse, but I have read interplanet janets reply, and I am still uncertain if statement 1) is true, or if statement 2) is true. Or if unknown?

thanks for clearing up,

LH

2 is correct, at least federally. Some states have penalties for early withdrawals from IRAs on top of the federal penalty, and I haven't evaluated all of them (just California, which appears to defer to the federal definition of which dollars are deserving of penalty).

This was not academic for me - at the time I started making backdoor Roth contributions, I starting to move my emergency fund into my Roth IRA to fund it. I researched this at the time to make sure that it was basically a zero-cost move for me in terms of flexibility (keeping the emergency funds inside the Roth in a safe short-term investment).

-janet

[madbrain]

Some people haven't noticed that 6%>0% (and it's per year)! The IRS may do nothing, but theoretically they could wait twenty years and then just swipe your entire balance.

Could they really go back twenty years ? I thought if they don't contest your tax returns after 7 years, it was too late for the IRS to contest it.
The 6% penalty applies only to excess contributions made in a given year. Not to the entire balance.
If the IRS contested the past 7 years, you would owe
5000 * 6% (7+6+5+4+3+2+1) = $8400 . Out of $35,000 of excess contributions. Ie. you lose 24% of your contributions.
Not quite sure what would happen to the earnings, but I believe you can keep them in the Roth.

[bottlecap]

This does not seem like a transaction to which the step transaction doctrine would apply. The doctrine seems to be applied to "transactions" in the sense that they are between two or more parties, when those parties structure the transaction in multiple parts so effect what would otherwise be a taxable transaction (for example) so as to avoid tax laws. The intervening steps are not against the law, but done for no other purpose to avoid consequences that would otherwise occur.

The distinction with the backdoor IRA is (at least) twofold:

First, a first blush, contributing to an IRA is not a "transaction" in the sense contemplated in the step transaction doctrine. It is simply transferring money into a different type of account. The owner is the same, so there is no "transaction." A conversion is similar. Thus there is no series of transaction designed to avoid taxes on a transfer. There are merely transfers of funds amongst accounts that are treated differently for tax purposes.

Second, both of these actions (contributing to a non-deductible IRA and converting a non-deductible IRA to a Roth) are expressly permitted under the law. This is a big distinction - they are not just "legal" or "not illegal", they are provided for by the Code. If the step transaction doctrine can apply to this transaction, you could arguably apply it to any two actions which together avoid taxes. I can't think of a good example off the top of my head, but my point is that the subset of "legal" or "not illegal" actions is vast. As a result, laws in general are susceptible to all manner of creative avoidance that can't be addressed by one or two laws to prohibit avoidance. This creates the need for a "step transfer doctrine" as opposed to piecemeal legislation. The subset of actions that are "expressly permitted by the rules by have (perhaps) unintended consequences" is not so vast (arguably!) and can be remedied by passage of a single law to close the loophole.

The distinctions here are subtle, but quite meaningful. I don't think the doctrine would be applied to two separate provisions of the Code that specifically address the permissibility of the actions, regardless of the consequence of combining them.

JT

[retiredjg]

I tend to agree with you bottlecap. It's just an instinct on my part and I could not put it into words. You did a nice job of it!

[interplanetjanet]

Ordering rules do apply, and a for a conversion in a given year the dollars that had to have tax paid to get them into the Roth come out first - and 10% will be owed on those in an unqualified distribution. For a "backdoor only" Roth this is obviously not an issue.

Thanks for responding. This prompted me to reexamine the instructions for Form 5329 (Additional Taxes on Qualified Plans (Including IRAs)
and Other Tax-Favored Accounts) and the rules for recapture amounts subject to additional tax on early distributions from Roth IRA conversions. I read the rules to say exactly what you indicated. The key is the amount of the conversion that was included as taxable income, which is $0 for a "perfect" back-door Roth conversion.

You're welcome, and I'm very glad this helped (and may help others). Pub. 590 could have been written to make this more clear, as it stands the term "disqualifying distribution" sounds like it just *has* to mean there's some kind of penalty that comes out of it. As I said in another thread, I stared at the publications and forms 8606 and 5329 and consulted tea leaves for a week before I took the plunge into putting my emergency fund into a RIRA.

-janet

[Default User BR]

Could they really go back twenty years ? I thought if they don't contest your tax returns after 7 years, it was too late for the IRS to contest it.

The statute of limitations is three years for most things, except criminal tax evasion.


Brian

[MichaelKitces]

Greetings everyone. Mamster just pointed out this thread to me, so I thought I'd take a moment to response to some of the confusion on this issue.

Ultimately, there are three separate concerns that have to be addressed in the contribute-then-convert strategy in the context I've presented it on my blog:
1) Does the strategy constitute a step transaction?
2) If #1 is true, what actions can be undertaken to avoid step transaction treatment?
3) If #1 is true, what is the likelihood of the IRS actually enforcing the rules?


Regarding #1, the reality is that the step transaction doctrine is a subjective, facts-and-circumstances-based test. If it walks like a duck and quacks like a duck, the IRS can tax it like a duck. Or in this case, if the clear intention is to simply circumvent the Roth contribution income limits by engaging in a series of separate steps that are separately allowable but in the end constitute an equivalent transaction, the IRS can tax it accordingly. Notably, the whole principle of the step transaction doctrine IS that each step INDIVIDUALLY is permissible and entirely legal, but the assembled series of steps constitutes an aggregate transaction that would have different tax consequences. By definition, the step transaction and its legal history applies ONLY where each step is individually legal. Otherwise, the step transaction doctrine wouldn't be necessary, because some individual step itself would have already run afoul of the law. So to suggest that the contribute-then-convert strategy must be permissible because each individual step is permissible is to ignore the entire step transaction legal precedent in the first place. The POINT of it is to catch transactions exactly like this!

With respect to #2, the answer again is "there is no clear, bright line test to avoid the step transaction doctrine, because it is a subjective facts-and-circumstances-based test." But the clear guidance we have from the existing case law is that the clearest way to defeat an assertion of the step transaction doctrine is the passage of time; the longer the interval between the steps, and the more possibility of intervening economic events and circumstances occurring, the less the IRS can assert that it "must" be the equivalent of a single transaction. How much time is necessary clearly varies by the commentator; Keebler advocates 6 months, Slott advocates just a few days. But notably, the fact that ALL of them suggest SOME amount of time to pass is a tacit acknowledgement that the step transaction doctrine IS an issue. If it wasn't, you'd simply to the entire transaction in the same day or even the same hour. So the reality that every commentator in this space suggests the passage of SOME amount of time makes it clear that there IS a step transaction issue. The debate - which unfortunately has no clear answer - is simply that we don't know how much time is "required" because of the subjectivity of the test. That's just the reality.

The third issue highlighted is the risk of getting caught for engaging in the transaction. Here, frankly, I think virtually all of us are in agreement that the odds are low. As I highlight in the blog myself, the odds you would lose IF caught are high (if there is little time between the contribution and conversion), but the odds of GETTING caught are quite low. The IRS has no clear mechanisms to track this kind of activity in any fruitful way, and the dollar amounts usually aren't large enough to merit witch-hunting in a random audit process. But the fact that the odds of getting caught are low doesn't change the fact that there IS still a step transaction issue here, much in the same manner that even if I don't get caught for driving 80mph, it's still illegal to do so.

As for penalties if you do get caught, the statute of limitations is generally three years, assuming that there is no substantial understatement of taxes (which is unlikely given the typical dollar amounts). However, the excess contribution penalty tax itself is a penalty tax that recurs. So, for example, if someone contributed $5,000/year for 5 years under the strategy, only the last 3 years would likely be open under the statute of limitations. However, in those last three years, the penalties would be 6% of $15,000 from year 3, 6% of $20,000 from year 4, and 6% of $25,000 from year 5 (or more if the account has some growth). Even though years 1 and 2 are past the statute, their excess contribution amount creates a recurring penalty that is still on the table for the last 3 years. So now we're talking about a total penalty of 6% x ($15,000 + $20,000 + $25,000) = 6% x $60,000 = $3,600 (in addition to being forced to unwind the contributions themselves, and the assessment of penalty interest for the delayed years). Still not exactly a tax catastrophe for most clients, but it certainly blows up a good chunk of economic value for an account that only had $25,000 of total contributions. And it's worth noting that when unwinding an excess contribution, only the LAST year's contribution can be recharacterized back to being a non-deductible IRA contribution; the remainder must actually be withdrawn, permanently forfeiting your IRA-sheltered contribution for those earlier years, and any earnings from the account will be subject to income taxes (since the extraction of earnings will be non-qualified) and a 10% early withdrawal penalty. So in the end, instead of just having $25,000 of non-deductible IRA contributions, the Roth strategy that gets caught ends out with $3,600+ in penalties, loss of tax deferral on $20,000 of contributions from the first 4 years that cannot be recharacterized, plus income taxes and 10% early withdrawal penalties on any growth. Again, not a tax catastrophe in the grand scheme of things, but it makes the consequences non-trivial relative to the dollar amounts that were involved in the first place.

It's also worth noting that the lack of IRS enforcement is a totally unacceptable legal defense in this regard. First of all, failure of the IRS to effectively enforce does not in any way foreclose on their ability to enforce a particular case that comes to light. Second, the IRS actually has little control to change these rules to close the "loophole" abuse anyway; Congress writes the laws, and the IRS simply enforces them. And to put it mildly, Congress is occupied with other matters right now; this is just not high on the radar. But again, the fact that it's been poorly enforced for the past two years means little. That's akin to saying that since we've had speed limits for decades and Congress hasn't passed a law to prevent vehicles from exceeding 65mph, it must be legal to speed. This is of course totally specious; the laws are what they are, and the fact that they are not perfectly enforced is in no way a defense to breaking them.


Of course, all of this is separate from dealing with the IRA aggregation rule if the client has other pre-tax IRA funds, which itself makes the strategy unappealing in many situations.

I hope that helps a little!

Respectfully,
- Michael


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[Bob's not my name]

the clear guidance we have from the existing case law is that the clearest way to defeat an assertion of the step transaction doctrine is the passage of time; the longer the interval between the steps, and the more possibility of intervening economic events and circumstances occurring, the less the IRS can assert that it "must" be the equivalent of a single transaction. How much time is necessary clearly varies by the commentator; Keebler advocates 6 months, Slott advocates just a few days. But notably, the fact that ALL of them suggest SOME amount of time to pass is a tacit acknowledgement that the step transaction doctrine IS an issue. If it wasn't, you'd simply do the entire transaction in the same day or even the same hour. So the reality that every commentator in this space suggests the passage of SOME amount of time makes it clear that there IS a step transaction issue. The debate - which unfortunately has no clear answer - is simply that we don't know how much time is "required" because of the subjectivity of the test. That's just the reality.

So if you hold the nondeductible TIRA in a money market fund for six months and then convert, does the time alone -- with no real "possibility of intervening economic events and circumstances" affecting the outcome -- do the trick?

Does the 30-day rule on wash sales establish precedent that 30 days is a sufficient time interval to defeat a step transaction finding?

If I contribute to my 401k out of my last paycheck prior to changing jobs, and then as soon as possible after separation roll my 401k to a TIRA, which has different rules for withdrawals and taxation and is therefore a distinctly different tax-sheltered vehicle, is that a step transaction?

Are in-service withdrawals of after-tax 401k contributions (a sort of back door Roth on steroids) a step transaction?

If instead of paying my kid's college tuition directly I gift him appreciated stock, he sells the stock without a tax consequence because he enjoys a 0% LTCG rate, and he pays the tuition himself with the proceeds, is that a step transaction?

Suppose I'm fully eligible to make a direct Roth IRA contribution, but I choose to make a deductible TIRA contribution on Dec 31 because I'm a single parent of triplets who graduated from college that year and I'm in the AOC phaseout and therefore have a 100% marginal rate. On Jan 1 I convert the TIRA to a Roth IRA, paying only 25% federal tax on the converted amount rather than 100%. Is that a step transaction?

If a regular converted Roth IRA declines in value and I use the recharacterize-reconvert trick, does that run afoul of step transaction doctrine?

[LBMM]

Retroactive punishments for activity that was legal at the time would likely be declared unconstitutional under ex post facto doctrine.

The ex post facto clause is limited to criminal penalties. Retroactive tax increases have already been approved by the U.S. Supreme Court. United States v. Darusmont, 449 U.S. 292 (1981).

[LBMM]

Everything is possible, but there is (I believe) no precedent for retroactively increasing taxes, which is what this would be.

United States v. Darusmont, 449 U.S. 292 (1981)

[bottlecap]

Michael:

If you look at what the step transaction doctrine is and the circumstances in which it is used, I would suggest it is wholly inapplicable. I also think the chances of applying tax penalties to conduct that is expressly permitted by statute, even if it is changed retroactively, are close to nil.

The fear you express is that the IRS will ask a tax court to apply a doctrine used to recapture avoided taxes in a transaction consisting of the transfer of (usually) business assets or entities to perfectly permissible actions under the tax code that do not Involve transactions or transfers of assets or entities. What evidence do we have that would suggest that a court would do this? If you've ever been involved in the sale of businesses or business assets, you are aware that there are a myriad of ways to structure the transaction to avoid taxes that haven't been expressly prohibited by law. The law can't provide against the ingenuity of millions of lawyers. With respect to the backdoor IRA, no such ingenuity is required, because the actions are not thought up by lawyers avoiding the code - the are expressly permitted under the code. This is much more easily feticide through legislation than through a tax suit. There a big difference in saying that the code allows me to take these actions to avoid taxes and saying that your lawyer figured a way around the taxes despite the code. That's when you begin to worry about the step transaction doctrine.

If you want to sound the alarm bell, there's no amount of convincing that will change that. But your post doesn't address any of these issues or suggest why a court, or the IRS, would apply the step transaction doctrine in a way that it never has before - the post simply restates your position. I submit that your concern involves an application of the doctrine completely out of context. I doubt that the IRS would take that position and don't think the courts would indulge them if they did.

JT

[retiredjg]

There had to be a reason when Congress dropped the income limits on conversion of tIRA to Roth IRA. Prior to the new law, higher income people could not convert. Under the new law, they can convert. It appears this change was an intended action, not an unintended consequence of some other action. If so, Congress clearly intended for higher income people to be able to convert.

If a you have a tIRA of $50k with no basis (such as a rollover IRA from a traditional 401k), and you make a non-deductible $5k contribution to IRA, you can convert it all and just pay tax on the $50k. It seems to me there is no possibility of a step transaction there. (In fact, I believe this could be exactly what Congress intended - to fill the coffers at the end of the Bush tax cuts.)

But what if the tIRA is $30k? $10k? $5k? How about $1k? And finally, what if the tIRA is only $1? If Back Door Roth is a step transaction, just where does the step transaction start?

I have no opinion on whether the back door contribution to Roth IRA is a step transaction or not. But even if it is a step transaction, the courts would have to determine a bright-line for where a step transaction starts in terms of my question above and in terms of time (some sort of waiting period). While I suppose this could happen, I do not believe that the IRS would go to any trouble to go back and unwind anything.

This is not the same as saying "go drive 85 on all highways". We all know where the bright-line is for that - it's located on those white rectangular signs right there on the highway. But these conversion cases don't have the white rectangular signs and nobody knows just what the law is or should be.

But it will be interesting to see how it unfolds.

[jared]

Could they really go back twenty years ? I thought if they don't contest your tax returns after 7 years, it was too late for the IRS to contest it.

The statute of limitations is three years for most things, except criminal tax evasion.

As for penalties if you do get caught, the statute of limitations is generally three years, assuming that there is no substantial understatement of taxes (which is unlikely given the typical dollar amounts). However, the excess contribution penalty tax itself is a penalty tax that recurs. So, for example, if someone contributed $5,000/year for 5 years under the strategy, only the last 3 years would likely be open under the statute of limitations. However, in those last three years, the penalties would be 6% of $15,000 from year 3, 6% of $20,000 from year 4, and 6% of $25,000 from year 5 (or more if the account has some growth). Even though years 1 and 2 are past the statute, their excess contribution amount creates a recurring penalty that is still on the table for the last 3 years.

I really have no idea whether or not the step transaction doctrine would apply, but if it did apply, I don't believe the typical 3 year statute of limitations would help you. The excise tax is reported on Form 5329. Form 5329 is a separate tax return from Form 1040. If Form 5329 is never filed, then the statute of limitations is never started. Don't take my word for it. Check out this tax court case: (http://www.ustaxcourt.gov/InOpHistoric/ ... TC.WPD.pdf) The whole case is interesting, but pay specific attention to pages 12-15, discussing the court's opinion regarding statute of limitations for excise tax on a timely filed Form 1040. Here are a few excerpts:

Section 6501(a) provides the general rule that the amount of
any tax imposed by the Code shall be assessed within 3 years of
the filing of the return. However, in case of a failure to file
a return, the tax may be assessed “at any time”. Sec.
6501(c)(3).

The resolution of this issue is governed by the Supreme
Court’s decision in Commissioner v. Lane-Wells Co., 321 U.S. 219,
223-224 (1944). Springfield v. United States, 88 F.3d 750, 752
(9th Cir. 1996).

[[A] taxpayer does not start the statute of limitations
running by filing one return when a different return is
required if the return filed is insufficient to advise the
Commissioner that any liability exists for the tax that
should have been disclosed on the other return * * * the
relevant inquiry is whether the return filed sets forth the
facts establishing liability. * * * Id. (citing Commissioner v. Lane-Wells Co., supra at 223). “Of
crucial importance is whether the return, as filed, included
sufficient information to allow the IRS to compute the taxpayer’s
liability”. Atl. Land & Improvement Co. v. United States, 790
F.2d 853, 858 (11th Cir. 1986).

Section 4973 imposes an excise tax on excess contributions
to Roth IRAs which is to be reported and disclosed on Form 5329.
Upon review of Mr. Paschall’s Forms 1040, respondent was not
reasonably able to discern that Mr. Paschall was potentially
liable for a section 4973 excise tax. While a line on each Form
1040, i.e., line 54 for 2000, line 55 for 2001, line 58 for 2002,
line 57 for 2003, line 59 for 2004, and line 60 for 2005 and
2006, states “Tax on qualified plans, including IRAs, and other
tax-favored accounts. Attach 5329 if required”, Mr. Paschall
left these lines blank, giving respondent no indication of his
excess contribution.
We hold that the filing of the Forms 1040 did not start the
statute of limitations running for purposes of the section 4973
excise tax in the absence of accompanying Forms 5329.

Again, I'm not saying that the step transaction doctrine would or wouldn't apply or that backdoor Roth is legal/illegal, I just wanted to point out some interesting information regarding the statute of limitations for excise tax.

[DavidC]

FYI additional discussion of this including some funny alternative names for "Backdoor Roth" are here

[baw703916]

There had to be a reason when Congress dropped the income limits on conversion of tIRA to Roth IRA. Prior to the new law, higher income people could not convert. Under the new law, they can convert. It appears this change was an intended action, not an unintended consequence of some other action. If so, Congress clearly intended for higher income people to be able to convert.

Yes, in fact there was indeed a reason. This was part of the tax cuts in the early part of the last decade. At the time budgeting was done under "pay-go" rules, and so there needed to be some projected increased revenue in the applicable 10-year window. Congress' solution was to allow Roth conversions without income limits in 2010, on the theory that a lot of taxes would be paid on conversions.

[tfb]

If you want to sound the alarm bell, there's no amount of convincing that will change that. But your post doesn't address any of these issues or suggest why a court, or the IRS, would apply the step transaction doctrine in a way that it never has before - the post simply restates your position. I submit that your concern involves an application of the doctrine completely out of context. I doubt that the IRS would take that position and don't think the courts would indulge them if they did.

I believe the Backdoor Roth is legal but I'm also taking steps to undo my conversions in 2011 and 2012. Converting on the very next day is not a necessary element of Backdoor Roth. See Recharacterize Backdoor Roth.

[Sammy_M]

I believe the Backdoor Roth is legal but I'm also taking steps to undo my conversions in 2011 and 2012. Converting on the very next day is not a necessary element of Backdoor Roth. See Recharacterize Backdoor Roth.

Could you elaborate, here or on your blog, about the steps in re characterizing? thanks.

[bottlecap]

If you want to sound the alarm bell, there's no amount of convincing that will change that. But your post doesn't address any of these issues or suggest why a court, or the IRS, would apply the step transaction doctrine in a way that it never has before - the post simply restates your position. I submit that your concern involves an application of the doctrine completely out of context. I doubt that the IRS would take that position and don't think the courts would indulge them if they did.

I believe the Backdoor Roth is legal but I'm also taking steps to undo my conversions in 2011 and 2012. Converting on the very next day is not a necessary element of Backdoor Roth. See Recharacterize Backdoor Roth.

That would be too much work for me for what is, at best, a very remote possibility. I really think this concern is much ado about nothing and just gives financial writers something to write about. And if it were a real possibility that the IRS would be interested in pursuing this "novel" legal theory, a financial adviser isn't doing his clients any favors by shouting it from the rooftops. Why try to create a problem where none existed?

JT

[tfb]

Could you elaborate, here or on your blog, about the steps in re characterizing? thanks.

If your Roth is in Vanguard funds,
1. go to Vanguard home page for personal investors
2. click on Forms on the top right
3. type "recharacterize" in the "Search forms and literature by title or phrase" box
4. print form, fill out form, mail it in

[tfb]

That would be too much work for me for what is, at best, a very remote possibility.

I tend to agree with you but I also think "why push it when you don't have to?" If I can do something to make it a non-issue no matter what, I'd rather do that.

[retiredjg]

I believe the Backdoor Roth is legal but I'm also taking steps to undo my conversions in 2011 and 2012. Converting on the very next day is not a necessary element of Backdoor Roth. See Recharacterize Backdoor Roth.

tfb, thanks for updating your original "how to do it" post so that all the information is in one place. This is a reasonable approach to the problem of not knowing just what the IRS will/can do about this issue.

[Sammy_M]

Could you elaborate, here or on your blog, about the steps in re characterizing? thanks.

If your Roth is in Vanguard funds,
1. go to Vanguard home page for personal investors
2. click on Forms on the top right
3. type "recharacterize" in the "Search forms and literature by title or phrase" box
4. print form, fill out form, mail it in

So, are you transferring back $5,000, or are you transferring back (recharacterizing) the shares of whatever securities you bought with the $5,000? What if you no longer hold those same securities? Rebuy them just to transfer back?? Anyone know how the 1099R and amended 1099R will look?

[tfb]

So, are you transferring back $5,000, or are you transferring back (recharacterizing) the shares of whatever securities you bought with the $5,000? What if you no longer hold those same securities? Rebuy them just to transfer back?? Anyone know how the 1099R and amended 1099R will look?

Vanguard will crunch the numbers and figure out how much must be moved from Roth to Traditional. On the recharacterize form, you tell them from which funds they should take the money. I believe they will just transfer the shares, not sell them. When I answered 'yes' to the 'Did you recharacterize it?' question in the tax software, it said I should attach a statement with the date and the amount I recharacterized. Not sure if Vanguard will issue an amended 1099-R. If not, I imagine my statement will basically say to the IRS "ignore the 1099-R."

[LH]

1)

Money converted to a Roth IRA ends up in a state where it is subjected to a 5 year delay before it can be withdrawn without a 10% penalty (unless the account owner is over age 59 1/2 and has a Roth account open for at least 5 years).

2)

This used to be a commonly held belief around here, but it appears it is not correct.

If the money is not taxed upon conversion (as is the case with a true back-door contribution to Roth IRA), apparently there is no 5 year rule and that money is treated just like an ordinary contribution (available any time).

I'll let Interplanetjanet and Alan S. explain cause I sure can't.

I am sorry for being obtuse, but I have read interplanet janets reply, and I am still uncertain if statement 1) is true, or if statement 2) is true. Or if unknown?

thanks for clearing up,

LH

2 is correct, at least federally. Some states have penalties for early withdrawals from IRAs on top of the federal penalty, and I haven't evaluated all of them (just California, which appears to defer to the federal definition of which dollars are deserving of penalty).

This was not academic for me - at the time I started making backdoor Roth contributions, I starting to move my emergency fund into my Roth IRA to fund it. I researched this at the time to make sure that it was basically a zero-cost move for me in terms of flexibility (keeping the emergency funds inside the Roth in a safe short-term investment).

-janet

Thanks for your reply.

So, in our case, my wife had an IRA that had some pretax money, some after tax money in it. We converted it to Roth, paid the tax.

so in that case, the 5 year penalty would apply if we took money out of the Roth?

t

[SSSS]

To those advocating that this might be illegal:

Do you apply the same logic to persons intentionally over-paying taxes in order to acquire paper I Bonds via the tax refund method?

If not, why not?

Consider the most extreme case -- all the overpayment is sent along with a form 4868 extension a couple days before tax day, and then the actual return & bond purchase request is sent about a week later.

[interplanetjanet]

Thanks for your reply.

You're welcome!

So, in our case, my wife had an IRA that had some pretax money, some after tax money in it. We converted it to Roth, paid the tax.

so in that case, the 5 year penalty would apply if we took money out of the Roth?

Yes. The dollars come out "in order", by year of contribution or conversion. Dollars that had tax paid to do a Roth conversion are subject to the 5 year (and age 59.5) penalty, Pub. 590 has the ordering rules for dollars that enter a Roth during each year.

Here's a question I don't know the answer to - if my mom in law contributes her first Roth dollars now for the 2011 tax year (she has earned income) does the clock start at Jan. 1st, 2011 - making the 5 year point Jan. 1, 2016? Or does the clock start during the calendar year of the contribution?

-janet

[Alan S.]

So, in our case, my wife had an IRA that had some pretax money, some after tax money in it. We converted it to Roth, paid the tax.

so in that case, the 5 year penalty would apply if we took money out of the Roth?

If you took THAT money out within 5 years, the pre tax amount would be penalized but not the after tax part. Look on your 8606 reporting the conversion to see how much was taxed when you converted. Eg, if 10k was converted and you were taxed on 6k, the first dollars distributed from that conversion money would be deemed from the 6k taxable amount. The next 4k would not be penalized.

But you may also qualify for another penalty waiver because the conversion holding period for the 10% penalty is still just an early distribution penalty. Therefore, if you are 59.5, disabled, have high medical expenses or higher education expenses etc. the penalty on that 6k can be waived.

[Alan S.]

Here's a question I don't know the answer to - if my mom in law contributes her first Roth dollars now for the 2011 tax year (she has earned income) does the clock start at Jan. 1st, 2011 - making the 5 year point Jan. 1, 2016? Or does the clock start during the calendar year of the contribution?

Clock starts 1/1/2011, the year for which the contribution is made. But for conversions it is different. If she took money out of her TIRA in Dec, 2011 and did a 60 day rollover to a Roth IRA in late January 2012, she reports the conversion on her 2011 tax return because the distribution was in 2011. However, the CONTRIBUTION to the Roth IRA was in 2012 so if this conversion was her first Roth contribution of any type then the 5 year clock would start 1/1/2012 for purposes of determining the Roth holding period for qualification of the Roth IRA. But the withdrawal penalty for the 5 year holding period for conversions would start in 2011. This is confirmed by the Inst for Form 5329 showing that conversions showing on Form 8606 within the 5 year period are subject to the 10% penalty.

So not only are there two different 5 year holding periods for a Roth IRA, but the criteria for conversion holding periods can produce a a one year difference for the conversion early withdrawal period than for the qualification 5 year period. Doesn't happen often because only a small fraction of conversions are done by an indirect rollover bridging a calendar year.

[interplanetjanet]

Clock starts 1/1/2011, the year for which the contribution is made. But for conversions it is different. If she took money out of her TIRA in Dec, 2011 and did a 60 day rollover to a Roth IRA in late January 2012, she reports the conversion on her 2011 tax return because the distribution was in 2011. However, the CONTRIBUTION to the Roth IRA was in 2012 so if this conversion was her first Roth contribution of any type then the 5 year clock would start 1/1/2012.

Thanks for the quick reply. That's what I expected - we've talked about slowly converting some of her TIRA dollars that are going to be taxed at a low rate.

-janet

[Alan S.]

But note my edit in prior post about how measuring the two 5 year holding periods could actually differ. Adds some additional complexity.

[Gauntlet]

I read this thread with great interest because I did my first back door Roth contribution in 2011 and I am about to submit my 2011 tax return. Obviously, there is no consensus. I am not a CPA or lawyer but isn't the main point that everyone that does a back door Roth contribution is fully reporting all transaction to the IRS. I mean, it is not like we are hiding anything right? I thought this back door Roth move was pretty smart but now I wonder if I should just take it out and put it all in a taxable account. The reality is that if your adjusted gross income is over the limit that allows you to directly contribute to a Roth IRA, you can probably save enough for retirement without using this vehicle. Anyhow, I wonder if anyone else feels the same or if I am being overly cautious.