This story has been updated.
Most of Ray Edwards' clients make too much money to qualify to make direct contributions into a Roth IRA. But he still makes sure to direct much of their savings into the accounts, thanks to the so-called backdoor Roth conversion.
"I discuss it with all clients," says Edwards, director of tax services at large RIA Aspiriant, based in Los Angeles and San Francisco. "I never have anyone say, 'Oh no, I don' t want to talk about this.'"
Roth IRAs have soared in popularity since rules were changed in 2010 to reduce income limits on conversions from IRA accounts. But the phaseouts fully disqualify clients with high adjusted gross incomes -- single tax filers whose income is at least $131,000 for 2015, for instance, or married couples filing jointly with income at or above $193,000 -- from making direct contributions into Roths.
Clients with incomes above those thresholds can make nondeductible contributions to traditional IRA and then roll the money into Roth IRAs -- a method known as a backdoor conversion.
A big caveat, Edwards and other advisors say, is that clients must have converted all their pre-existing IRAs to Roths beforehand or risk incurring unwanted tax consequences. Once done, however, Edwards likes to have his clients use the backdoor strategy for their annual retirement contribution. "You are converting each year's annual contribution," he says, "as opposed to letting it build up for a number of years and then converting."
TIMING IS KEY
Edwards advises clients to do both the IRA contribution and the Roth conversion on the same day.
"The best way to use this backdoor is to put money into a IRA and then convert those assets on the very same day," Edwards says. Dawdling before converting can generate tax consequences, he adds. "Immediate conversion, before any income is earned, will result in no additional taxable income," he says.
Not all advisors back immediate backdoor conversions. After this story was first published, Pinnacle Advisory Group partner (and Financial Planning contributor) Michael Kitces tweeted his opposition to immediate conversion, which he says runs afoul of the IRS' step transaction doctrine.
Indeed, he argues, the very name ("backdoor") indicates it's likely to trigger IRS scrutiny and get clients "busted" for skirting tax laws.
"Tax court will use it to bury the client!" Kitces wrote, saying he knows of two advisors who ran afoul of this strategy with the IRS in the past year.
Edwards disagrees. Aspiriant uses the same-day conversion strategy routinely and documents it all and has never run into a problem with the IRS, he says; nor is the firm concerned that the strategy might prove problematic.
"This is a celebrated change in the tax law," Edwards says, adding that Congress knew precisely what it was doing when it made this change in 2010. "It was not an error. They did it on purpose. They went in and changed the existing law to permit anyone to convert regardless of their income.
"It's expressly provided in the tax code," Edwards says. "There has never been anything in the law that restricts your ability to convert on the basis of time."
Edwards recommended the following tips for using the backdoor Roth strategy:
- Check clients' time horizon. Edwards believes it works best for clients with the longest time horizons ahead of them before they begin taking distributions in retirement. Not all planners agree, though: Allan Roth, a Financial Planning contributor and founder of Wealth Logic in Colorado Springs, Colo., says he recommends backdoor conversions even for people who are about to retire. "You have nothing to lose by doing a backdoor conversion," Roth says.
- Watch the AGI phaseouts. The strategy is geared to clients who are disqualified from making direct contributions into Roths. Anyone able to contribute to Roths directly should do so, Roth says.
- Know all your client's accounts. Bear in mind that when determining the taxability of a conversion, the IRS requires that all of a client's traditional IRAs be treated as a single account. "So, you may have some IRA accounts that may have a lot of appreciation," Edwards says, "and other accounts with a little appreciation over the basis in them. But you are not able to go in and say, 'Well, I'd like to convert just those assets that have very little appreciation, so I'll minimize my taxable income. Instead the IRS would say if you distribute 1% of the total value of all of your IRAs, you are also going to be distributing 1% of the total basis that you have in all your IRAs. So the extent to which you have existing dollars in a traditional IRA, it will really limit the benefit of the backdoor conversion strategy." As a result, the strategy works best for clients who already have converted all their IRAs into Roths. That applies to most Aspiriant clients, Edwards says, because many of his clients made the conversions back in 2010. But for those who have yet to do so, he converts their IRAs to Roths before beginning to use the backdoor for future annual retirement contributions.
- Check for Form 8606. You can find out whether your clients have a history of making nondeductible IRA contributions for themselves or for non-working spouses by checking for a Form 8606 in their tax return. "You will see their basis in the IRA, which gives you a sense of what their contribution history has been," Edwards says. "If you see someone who's got a very low basis, that probably means theyve only been making contributions for a few years."Whenever I meet with a prospect," Edwards says, "I look a their return before the meeting."
- Watch the clock. Once a client makes a non-deductible contribution into an IRA, he or she should immediately shift that money into the Roth. "When I say immediately," Edwards says, "it can actually happen that same day. Our goal is to execute the conversion as soon as possible after the conversion so that there will be no income build-up that will be taxable upon the conversion." What's critical is that the basis of the investment be equal to the conversion amount, in order to generate no tax liability.
Finally, Edwards says, be prepared to educate your clients. Although many advisors are familiar with this backdoor strategy, Edwards says, a surprising number are not. So, be prepared to educate them about the process.
For clients without other IRAs, "there's really not a downside" to using the backdoor, Edwards says. Any pain clients experience from paying taxes now is offset by knowing they won't owe any later. "The idea that you can pull that money out, and the growth on it, for free is always an attractive goal," Edwards says.