Explain the Step Transaction Doctrine
Over the last year, I have read a number of articles related to the strategy of funding a traditional, non-deductible IRA and immediately converting to a Roth IRA. (There are no other IRAs so no "cream in the coffe" and no tax would be due.) I recently came across an article that expressed some concern about this strategy citing that the IRS could apply the step transaction doctrine to combine both steps into a single transaction and tax it accordingly.
Could you review the "step transaction doctrine" and state whether this is an appropriate concern? If so, kindly explain how you would structure the conversion in order to alleviate the concern.
Thanks in advance.
The step transaction doctrine can be a bit complicated, but essentially, when applied it treats what are actually several independent steps as if they were a single transaction for tax purposes.
There are three different tests which have been used to determine if the step transaction doctrine should apply. One test, commonly referred to as the “binding commitment test” applies when there is a commitment to complete a later step in an overall transaction at the time the first step is made. Since an IRA contribution (deductible or not) does not require that one convert the contribution to a Roth IRA, this test is a non-factor here.
Another test that is used to determine if the step transaction doctrine should be applied is the “mutual interdependence test.” This test looks at each step in an overall series of steps and determines if a specific step is meaningless unless the later step(s) actually occurs. Since a non-deductible IRA contribution is clearly beneficial (read “not meaningless”) on its own, this test is also a non-factor.
The third and final test, known as the “end result test,” is the most applicable for this discussion. Under the end result test, the steps in a transaction are looked at to see whether the series of steps were really just predetermined steps of a single, overall transaction, aimed at achieving a specific outcome. Do clients make IRA contributions with the idea that they will later convert them? Sure. So is it possible for IRS to raise issues with this strategy in the future? Yes, but it’s not a likely scenario.
For starters, it’s clear that Congress expressly and intentionally allows taxpayers to make non-deductible IRA contributions. It’s also clear that Congress’ intent is to allow taxpayers with IRAs to convert them to Roth IRAs, regardless of their income. Secondly, how would IRS even apply this rule? How long would someone have to wait to complete step 2 (converting to Roth) after completing step 1 (non-deductible contribution) without IRS applying the step transaction doctrine?
My general advice to clients who cannot make contributions directly to a Roth IRA (due to high income) is to make the contribution to their IRA first, let it stay there for at least a day or two - so it shows up on at least one traditional IRA statement - and then convert it to a Roth IRA.
Rollovers and Conversions
Hi Ed and team!
Client has funds in a company plan. The funds are in a Section 401(a) after tax account inside the company plan. The funds consist of $50,000 of post tax contributions (basis) and $20,000 of earnings from the 401(a) source funds.
We would like to do a Roth IRA conversion of the full $70,000. This would NOT be an in-plan Roth conversion but a conversion of in-plan funds directly to a Roth IRA allowed under The Small Business Jobs Act of 2010.
If we convert directly from the company plan to the Roth IRA, the taxable amount on the conversion will only be the $20,000 of earnings from the 401(a) source, as only the 401(a) funds are considered for the conversion. Is that correct?
If we do a rollover of the funds to a rollover IRA, and then try to convert that amount to a Roth IRA, then the conversion will have to consider ALL other IRA’s owned by the participant. Is that correct? (The participant already has a $100,000 Rollover IRA with zero basis from previous job)
I am just trying to be sure that my strategy is appropriate!