4 warnings about using back-door Roth IRAs

More of your high-income clients can now move funds to Roth IRAs by using the so-called “back-door Roth” strategy. Unlike traditional IRA contributions, Roth IRA contributions have income limits, but this strategy allows funds to be moved to Roth IRAs even when income exceeds the Roth IRA limits.

For 2018, individuals cannot make a Roth IRA contribution if their income exceeds $199,000 (married, filing jointly) or $135,000 (single).

The back-door Roth is a work-around that lets people move funds to a Roth IRA even if they don’t qualify for a Roth contribution because of the income limits. They can make a nondeductible contribution to a traditional IRA (if they qualify — they must have earned income) and then convert that contribution to a Roth IRA. Congress has said this is a legal strategy.

In the past, some were worried that the IRS would attack this work-around, but no more. While it’s not specifically part of the Tax Cuts and Jobs Act, here is one of several references from the conference report confirming the use of the back-door Roth: “Although an individual with AGI exceeding certain limits is not permitted to make a contribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA.”

But see the four warnings below before you advise clients on this.

(More: New tax law provides opportunity for tax-rate arbitrage on Roth IRAs)

Cautions on using back-door Roth IRAs

1. Clients must have earned income, such as wages or self-employment income; otherwise they don’t qualify to make a nondeductible IRA contribution, which is the first step in this process.

For married couples filing a joint return, the back-door Roth IRA benefit can be doubled by having the nonworking spouse also do this. Spouses with little or no income may qualify even though they don’t meet the earned income requirement, providing they file a joint tax return and the working spouse has sufficient earned income to cover the contributions for the nonworking spouse. Also, the nonworking spouse cannot be over 70½, which is the next caution.

2. The back-door Roth IRA won’t work if your client is 70 ½ years old or older. That’s because there are age limits for making traditional IRA contributions. You cannot make a traditional IRA contribution (deductible or nondeductible) for the year you turn age 70½ or later years. Clients who exceed the age limit cannot use the back-door Roth IRA strategy. Roth IRAs have no age limits, but this won’t help since the actual IRA contribution is being made to a traditional IRA, not a Roth IRA.

3. The pro rata rule will apply. All owned IRAs, including SEP and SIMPLE IRAs, are included in the pro rata calculation. However, this only means that some of the conversion may be taxable, so don’t tell clients that their Roth conversion in this process will be tax-free, unless they have no other IRAs.

4. The funds that end up in the Roth IRA through a back-door conversion are converted funds, not Roth IRA contributions. This makes a difference for those under age 59½, who must wait five years for penalty-free access to those funds. If the funds went in as Roth IRA contributions, they would be accessible immediately, tax- and penalty-free.

Even though the funds go in as a Roth conversion, the nondeductible traditional IRA contribution can still be made for 2017 (if done by April 17, 2018) but the conversion will be a 2018 Roth conversion.

Clients who have yet to make a 2017 IRA contribution can double up by making traditional IRA contributions for both 2017 and 2018 and then converting the total to a Roth IRA. That can allow a couple age 50 or over to move $26,000 to Roth IRAs right now ($6,500 each, for each year, assuming they qualify).

(More: How to help millennials avoid big mistakes with their IRAs)