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Will the IRS Disallow Backdoor Roth Contributions?

Written by Nickel - 9 Comments

I’ve talked quite a bit about making “backdoor” Roth contributions if you’re over the income limits for contributing to a Roth IRA. In short, you can make a non-deductible contribution to a traditional and then immediately convert it into their Roth.

This strategy has become so popular that mainstream publications such as Forbes have started talking about it. But is it legal? That was the topic of a recent discussion over on the Bogleheads forum.

This discussion was prompted by an article by Michael Kitces, who is a financial planner extraordinaire and the Director of Research for the Pinnacle Advisory Group.

According to Kitces, while the individual steps of the backdoor Roth maneuver don’t run afoul of IRS regulations, these contributions could be disallowed under the step transaction doctrine.

The step transaction doctrine is a legal principle that essentially allows the IRS to look at the overall effect of a multi-step transaction and treat it as a single, integrated event.

In other words, rather than looking at the legality or tax treatment of individual steps, the IRS is free to look at the overall result of the transaction — i.e., that an individual over the contribution limits was able to make a Roth IRA contribution — and tax (or penalize) it accordingly.

So… The question is whether or not the IRS would balk at backdoor Roth contributions. I’m not particularly concerned about it, in part because the removal of income limits for converting funds to a Roth IRA appears to have been specifically intended to allow high income individuals to do just that, but…

It seems at least theoretically possible that the IRS could view this as an over-contribution, which comes with a recurring penalty of 6%/year (albeit with a 3 year statute of limitations), and these transactions could be messy to unwind.

At the same time, it’s worth noting that IRA expert Ed Slott weighed in on this issue last spring, arguing that the step transaction doctrine is a non-issue for backdoor Roth contributions.

My pal TFB has also tackled the subject. The short version is that he’s recharacterizing his recent conversions, and will re-convert at a later date to reduce the odds of his conversions being viewed through the lens of the step transaction doctrine.

What about you? If you’ve been making backdoor Roth contributions, are you concerned about running afoul of the IRS?

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Published on February 1st, 2012
Modified on February 6th, 2012 - 9 Comments
Filed under: Retirement, Saving & Investing, Taxes

About the author: Nickel is the founder and editor-in-chief of this site. He's a thirty-something family man who has been writing about personal finance since 2005, and guess what? He's on Twitter!

9 Responses to “Will the IRS Disallow Backdoor Roth Contributions?”

1
taxhobbyst Says:
February 1st, 2012 at 11:14 am
Nina Olson (National Taxpayer Advocate employed by the IRS) now has a tax blog. Why not ask her? I recognize it is her opinion but it would be a pretty high up the ladder opinion?

http://www.taxpayeradvocate.irs.gov/Home/Blog
2
Chucks Says:
February 1st, 2012 at 11:27 am
It’s a tough call, because while the removal of income limits for conversions of IRAs to Roths does seem to allow for backdoor contributions, you have to wonder why income limitations for Roth contributions wouldn’t have also been eliminated. I spoke with an IRA company that seemed to believe this was all legal and good. I would have to imagine that if this was an issue the IRS would have already issued some sort of guidance.
3
TFB Says:
February 1st, 2012 at 12:06 pm
Thank you Nickel for the link. While I still believe it’s perfectly legal, I also think there is no reason to push it to the extreme unnecessarily. Putting in a time buffer will still preserve 99% of the benefits from Backdoor Roth.
4
yourPFpro Says:
February 1st, 2012 at 4:14 pm
The IRS set the contribution limit on a Roth IRA for a reason. They do not want people with AGI’s over 107k contributing to a Roth IRA. I say if you can get away with the backdoor Roth, go for it! But beware, the IRS has the right to come after you one day..
5
retirebyforty Says:
February 1st, 2012 at 6:16 pm
I haven’t heard much about backdoor Roth, but it sounds like a good plan for people over the limit. I should check into this more.
6
SomeGuy Says:
February 2nd, 2012 at 12:12 pm
Another option if you have non W2 income is to set up an individual (aka solo) 401(k). Vanguard has low or no fee solo 401(k) options and you can choose to set up both a traditional pre-tax 401(k) and a post-tax Roth 401(k). It’s quite easy to set up and maintain and you can move money directly from a checking account into the Roth 401(k), without going through special hoops.
7
Long Says:
February 3rd, 2012 at 1:10 pm
I’ve done it for the past two years. I’m not concerned about it either. I think that if it was making that big of an impact on tax revenue, there will be a quick addition to the tax code that will disallow the action.

I hope you don’t mind, but to echo your post, I recently wrote a how-to on my own site on how to contribute to a Roth IRA via the backdoor method. I think everyone who is not qualified to contribute to a Roth IRA directly should take advantage of the loophole for as long as it exists.
8
JM Says:
February 3rd, 2012 at 9:28 pm
The step transaction doctrine is usually a losing argument for the IRS.
9
White Coat Investor Says:
February 9th, 2012 at 12:32 am
I’m going into my third year of doing backdoor Roth IRAs. I’m really not worried about the step transaction doctrine. Plus a 3 year statute of limitations? At most I’d have to unwind $30K in backdoor Roths. Trivial compared to the benefits. This is money that would otherwise be in a taxable account.

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