In 2010, the tax laws were changed to eliminate the income limits on conversions from Traditional IRAs to Roth IRAs. Since Roth IRAs still have income limits on direct contributions, this opened up a “backdoor” where high-income individuals could first contribute to a non-deductible Traditional IRA and then immediately convert to a Roth IRA. If there were no capital gains upon conversion, there would be no taxes due. Thus, the term “Backdoor Roth IRA”.
Some financial experts fretted about the legality of this move due to something called the step transaction doctrine. Some financial advisors instructed people to take special steps to help ensure the legitimacy of their Roth IRA conversions. You also have to be careful if you have other Traditional IRA accounts that you are not rolling over (“IRA aggregation rule”).
Even with all this discussion, there was never any official acknowledgement of this tax move. In past years, there were explicit budget proposals that would have curbed this option. Some argued that this talk itself was implicit acknowledgement that it was legal. Confused yet?
Apparently, the official acknowledgment finally came with the new tax law when they stopped allowing Roth IRA recharacterizations (undos). According to this Forbes article Congress Blesses Roth IRAs For Everyone, Even The Well Paid, a conference committee report by Congress included the following footnotes. Thanks to reader Abel for the tip.
268 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, as discussed below.
269 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.
276 The provision does not preclude an individual from making a contribution to a traditional IRA and converting the traditional IRA to a Roth IRA. Rather, the provision would preclude the individual from later unwinding the conversion through a recharacterization.
277 In addition, an individual may still make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA, but the provision precludes the individual from later unwinding the conversion through a recharacterization.
Do these footnotes end all speculation? Ed Slott seems to think that this indicates “intent” by Congress, and he is a respected tax source. The same conclusion is also drawn by Natalie Choate in this Morningstar article.
Both my wife and I have made non-deductible Traditional IRA contributions every year since 2010. I think if it was really an “unintended loophole”, they would have closed it by now (as with Social Security benefits). I am not a tax professional, I’m just a guy who wishes we didn’t need experts to interpret every little thing. If there were any people who needed additional convincing, perhaps this will give them the confidence to proceed.
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