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?