Q: Hi Dan, I enjoy the advice you provide and I have a question. I am over the income limit to contribute to a Roth IRA. I funded a traditional IRA with $5,500 of money from my savings account in 2018, so it was with posttax dollars. I converted that amount a few weeks later to a Roth IRA at a loss (only about $5,400). Am I correct in assuming that I do not have to pay taxes on the converted money now (or when I withdraw it in retirement) as long as I do not deduct the traditional IRA contribution on my taxes?
Also, I’d like to do this for 2019 as well. Can I convert as soon as I fund the traditional IRA or do I need to wait a few weeks?
Thank you,
Andrea
A.: You are correct that there will be no tax on the conversion as long as you have no untaxed money in any other IRA. However, if you had any untaxed money in any other IRA, including SEP-IRAs and SIMPLE-IRAs, you have to deal with the pro rata rules. I wrote about how that works most recently in I need help with a Roth IRA conversion.
The act of making a nondeductible contribution then converting it to a Roth is often referred to as a “back door Roth IRA”. There is some debate about the proper timing of this conversion.
Read: Here’s why you may want to reconsider doing that backdoor Roth IRA conversion
At issue is a concept called the “step transaction doctrine” which relates to “a series of transactions designed and executed as parts of a unitary plan to achieve an intended result ... will be viewed as a whole regardless of whether the effect of so doing is imposition of or relief from taxation.” FNMA v. Commissioner, 896 F.2d 580, 586 (D.C. Cir. 1990).
In other words, if a series of steps are allowed but the result is prohibited, the series of transactions can be disallowed. It is fine for high income taxpayers to make a nondeductible contribution and it is permissible to convert, regardless of income but it is not allowable for a high income taxpayer to make a contribution to a Roth. The back door methods end result looks a lot like a direct contribution, especially if the conversion is done immediately after the nondeductible contribution is made.
Recent comments by tax authorities state clearly, there is no problem with the back door Roth IRA, per se. As a result, some tax advisers say converting immediately after the nondeductible contribution is made is best. However, the official comments do not explicitly say it’s OK to convert immediately so other tax advisers say to wait. How much time should pass between the contribution and the conversion? Well there is debate about that, too.
Some advocate for a specific amount of time. Others say wait until some interest is received so that tax is due on that part of a conversion. In that case, the tax due would be tiny. Still others say wait until the tax year after the tax year the original after-tax contribution was made.
So, I can’t say with certainty that waiting a few weeks will be fine. All that said, I have yet to see a report condemning anyone for using the back door Roth approach due to how long they waited to convert.
If you have a question for Dan, please email him with “MarketWatch Q&A” on the subject line.
Dan Moisand’s comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.
