Obama Budget Proposal Seeks to Axe Backdoor Roth IRA Conversions

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Question:  The White House budget targets “backdoor” Roth IRA contributions. This is a strategy that supposedly allows taxpayers to make a non-deductible contribution to a traditional IRA and then convert it into a Roth IRA. If true, this is a powerful strategy for high earners in high tax brackets. It lets you bypass income limitations that otherwise apply to Roth IRA contributions. And with a Roth, there’s no further tax liability as long as you comply with the IRS withdrawal rules. The Obama budget would put an end to this strategy by limiting Roth conversions to pre-tax dollars only. Is this strategy valid?

Answer:  For 2015, the combined contributions to all of your traditional and Roth IRAs cannot be more than $5,500 ($6,500 if age 50 or over) or the amount of your taxable earned income, whichever is less.  Your contribution to a traditional IRA account is deductible, which is subject to certain income limitations. 

Single Filer

If you are not covered by a retirement plan and your filing status is single, then there is no income limitation.  If you are covered by a retirement plan at work, you can deduct the full amount of your IRA contribution if your Modified Adjusted Gross Income (MAGI) is under $61,000.  Your deduction is phased out between $61,000 and $71,000.

Married Filing Jointly

If you are filing as married filing jointly, and your spouse is also not covered by a retirement plan at work, then there is no income limitation.  If your spouse is covered, then your contribution is deductible if your MAGI is less than $183,000, and your deduction is phased out between $183,000 and $193,000.  If you are covered by a retirement plan at work and your filing status is married filing jointly, then you can deduct up to the amount of your contribution limit if your MAGI is under $98,000 and your deduction is phased out between $98,000 and $118,000.

Roth IRA

The $5,500 ($6,500 if age 50 or over) limit also applies to Roth IRA contributions.  However, your Roth contribution might also be limited by your filing status and income.  If your filing status is single, then your Roth contribution limit is phased out between $116,000 and $131,000.  If your filing as married filing jointly, your contribution limit is phased out between $183,000 and $193,000.  Roth IRAs are desirable because the money will grow tax-deferred and can be withdrawn tax-free, subject to withdrawal rules.  

The “backdoor” Roth that you asked about is a way for taxpayers with incomes above the phase-out limits to make an annual contribution to a Roth IRA. If you are above the income limits you can contribute to your traditional IRA and then convert that contribution to a Roth by rolling it over to a Roth IRA. 

Despite what you might read elsewhere, the conversion may not be tax-free.  If you have any pre-tax money in a traditional IRA account, then you must prorate the conversion amount by the ratio of taxable versus nontaxable money in all of your traditional IRA accounts to determine the taxable amount of the conversion.  Taxpayers who want to employ this strategy should talk to their tax practitioner and follow IRS Roth conversion rules.

Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment advisor and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning.  Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA  93940 or email them to ken@montereypw.com.