When to show HNW clients the Roth IRA back door

If you have high-net-worth clients who are looking for ways to put away the maximum possible in their retirement accounts, it may be time to show them how they can supersize their retirement accounts with the mega-backdoor Roth IRA contribution strategy.

But first, a few caveats:
• This strategy only works for individuals with significant resources and income who have already maxed out contributions to their other retirement accounts.
• The client’s 401(k) plan must allow for non-Roth, after-tax contributions to the plan.
• You (perhaps in concert with the client’s tax advisor) will need to help the client carry out the strategy in a way that avoids the IRS aggregation rule and prohibition on step transactions.

The concept of the backdoor Roth conversion isn’t new. When Congress raised the income limits on eligibility for Roth conversions in 2010, higher-income taxpayers were able to contribute to a nondeductible traditional IRA and then convert it to a Roth IRA a short time thereafter.

For married couples filing jointly whose income is $199,000 or greater in 2018, contributions to a traditional IRA are not deductible, and those same taxpayers are disqualified altogether from contributing to a Roth IRA. However, a high-income individual might make a nondeductible contribution to a traditional IRA and subsequently convert it to a Roth account in order to obtain the ability to make tax-advantaged withdrawals from the account in retirement. Their ability to make contributions to a Roth IRA is curtailed, but not their ability to convert an existing traditional account to a Roth account (note that the 2018 tax law ended the ability to reverse a Roth conversion by converting it back into a traditional account).

Some clients run into a complication from the IRS aggregation rule while executing this strategy, though. IRC 408(d)(2) stipulates that “all individual retirement plans shall be treated as one contract” and that “all distributions during any taxable year shall be treated as one distribution.” This means that if a client had any traditional IRA accounts in place at the time the Roth conversion was performed, the distributions from the converted accounts would be treated the same way as the distributions from traditional accounts, since the IRS rule aggregates all accounts for tax purposes (for more on this, see Michael Kitces’ 2015 article on the subject).

Fortunately though, 401(k) accounts are not subject to the aggregation rule. This means that any assets held in such employer-sponsored plans will not fall afoul of IRC 408(d)(2). In fact, clients may roll over funds from traditional IRA accounts into 401(k) accounts and thus insure that the aggregation rule will not apply to subsequent distributions from those assets. This assumes, of course, that the client’s 401(k) plan permits rollover contributions from outside tax-qualified accounts.

Now we get to the good part. Let’s suppose you have a high-net-worth client who is highly focused on both saving for retirement and leveraging tax-advantaged growth in her invested assets. She has already made the maximum allowable contribution to her other tax-qualified plans, including her health savings account, her IRAs and her regular 401(k) contribution. But she wants to do more. How do you advise her?

You suggest that she make a non-Roth after-tax contribution to her 401(k). You will need to help her check her plan documents to make sure that the plan allows such contributions. Ideally, of course, your client enlisted your aid in designing her plan in the first place, so you made sure that the plan document was drafted to permit these contributions. In that case, she can contribute up to the maximum allowed for all types of contributions (employee contributions, employer contributions and non-Roth after-tax contributions). For 2018, the maximum allowed for all contributions is $55,000 (see IR-2017-177).

So, supposing that your client’s employer (likely the client herself) had contributed $10,000 to her 401(k), she would be able to put in another $26,500 ($55,000 - $10,000 - $18,500). Her contribution is nondeductible, but it may be withdrawn tax-free. It will accumulate in a tax-free environment, and when the earnings are withdrawn, they would be taxed as ordinary income. Unless, of course, you advise your client to take the next step.

Once the client has contributed the after-tax funds to the 401(k), she can roll them over into a Roth IRA. The rollover is a tax-free event, and because the assets are now in a Roth IRA, both the contribution and the subsequent earnings may be withdrawn tax-free. The only portion of any distributions that would be taxable is the amount earned by the assets while they were in the 401(k). Ideally, the rollover took place relatively soon after the 401(k) contribution, and as such, any earnings would be negligible.

David Paul Morris/Bloomberg

Here is the major caveat that I must mention at this point: The IRS step-transaction doctrine which originated in 1935, holds that separate steps in a chain of transactions that have no inherent business purpose may be treated as a single tax event. In other words, if the non-Roth contribution to the 401(k) and the subsequent rollover to a Roth IRA are performed in close chronological proximity, the tax court may rule that the intent was to make an otherwise impermissible Roth contribution, which the court might then disallow. This would likely result in a 6% penalty for excess contributions to a qualified plan.

Advisors take different positions on the best way to avoid trigger that doctrine. The most conservative planners advise waiting a full year before rolling over the funds from the 401(k) to the Roth IRA. Others suggest waiting a month (a typical account statement cycle) to make the move. But perhaps the most important measure in avoiding the application of the step-transaction doctrine is to simply avoid any mention of a backdoor Roth conversion. In your written communications with the client and your notes in the client’s file, do not use the terms “backdoor Roth” or “Roth conversion.”

The crucial step for the tax court is to establish the client’s intent to bypass the income limits on Roth contributions. By being circumspect in your communications with your client, you won’t be assisting the IRS in making its case, should anyone in the Treasury Department become curious about your client’s Roth assets. Especially for non-CPA practitioners, whose records are typically not protected by advisor-client privilege, it is vital to be careful what you say and what you write.

On the other hand, many experts believe that the IRS is unlikely to come after taxpayers who have done backdoor Roth conversions. For example, Jeffrey Levine cites his inability to discover a single case where the IRS has faulted a conversion by appealing to the step-transaction doctrine.

So, to summarize, here are the steps (and cautionary tips) for implementing the mega-backdoor Roth conversion strategy:

1. Client maxes out annual contributions to all tax-qualified plans, including 401(k).
Pro tip: Don’t forget the HSA!

2. Client makes a nondeductible, non-Roth contribution to 401(k), up to the permissible annual limit.
Pro tip 2: Use of the 401(k) avoids the IRS aggregation rule.
Pro tip 3: When possible, advise self-employed clients to design their 401(k) plans to permit non-Roth employee contributions.

3. Client rolls over the non-Roth contribution from the 401(k) into a Roth IRA account.
Pro tip 4: Take care to avoid language that indicates the client’s intention to circumvent the limits on Roth contributions.

Pro tip 5: It’s smart to allow some time to elapse before the rollover. Just remember that any accrued earnings before the rollover will be taxed upon withdrawal.

When implemented properly, the mega-backdoor Roth strategy can help your high-net-worth clients set aside tens of thousands of extra dollars each year. These assets will accumulate tax-free and provide nontaxable income in retirement.

This back door can lead to huge benefits both for your client and for the advising relationship.