Breaking the Code: Unconventional Roth Conversion
By: Tony Khalife, CPA, MST, CFP®
When we use the term Roth Conversion, most clients and practitioners think of the traditional planning opportunity that involves converting your Traditional IRA directly to the Roth IRA. This is often done when the taxpayer is in a low tax bracket in a given year or there are larger estate planning considerations for the next generation.
One unconventional approach to this “traditional” idea is the use of an exception under IRC Section 408(d)(3)(H) – I’ll present some facts and an example below (versus reciting Code).
Facts:
You are a W-2 employee and work at a company that offers a 401(k) plan
The 401(k) plan at your company allows for in-service contributions or rollovers from your IRA
You have a Traditional IRA balance with both pretax and after-tax (nondeductible) contributions
Normally, the traditional planning opportunity is to fund a Traditional IRA with nondeductible contributions. Assuming those are your only contributions to the IRA, you would then convert the Traditional IRA to a Roth IRA (known as a Back-Door Roth). This results in no income tax implications as the original contribution to the IRA was nondeductible to start.
If you have rollovers from old 401(k) plans to your IRA or made deductible IRA contributions in the past, the Back-Door Roth does not “work.” The Code requires pro-rata allocations between pretax and after-tax contributions. If you try to convert your Traditional IRA with both types of contributions, you would have a portion of the Conversion that is taxable to you (versus nontaxable with the Back-Door Roth).
The exception under IRC Section 408(d)(3)(H) allows you to “split” up your pre-tax and after-tax contributions. You can use the exception to roll any pre-tax contributions (and related earnings) to your employer’s existing 401(k) plan (assuming the plan allows for this). Once this is complete, all that is left in your Traditional IRA are your nondeductible contributions. You may then convert your nondeductible contributions to a Roth IRA. The income tax implications are minimal (only taxed on any earnings related to the contributions) – the nondeductible contributions themselves would not be taxable income at the time of conversion. Now you can utilize the Back-Door Roth annually going forward!
This is certainly a unique exception for a unique set of facts and circumstances but could be helpful in some situations for some clients. As always, we are happy to discuss this and review for your individual tax situation.
To ensure compliance with the requirements imposed on us by IRS Circular 230, we inform you that any tax advice contained in this communication (including any attachments) is not intended to and cannot be used for the purpose of: (i) avoiding tax-related penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any tax-related matter(s) addressed herein.