How "secret" or "taboo" is the Backdoor Roth?

[DMFA]

Got an email from Fido today linking to their standard, bread-and-butter info on IRAs with a bait-like title: Seven things you may not know about IRAs. Nothing an in-the-know solo-flying saver-investor (three hyphens in a row!) like most of us wouldn't know, but a good hit for the Average Joe, in my opinion.

One thing I was interested to see is point #7, which talks about what to do if above the income threshold for Roth contributions, which we all (most?) know: the non-deducted TIRA contribution then converted to Roth, which we affectionately know as the Backdoor Roth.  They basically tell you to do exactly that:

"If you don’t have a traditional IRA you’re still not out of luck. You could open a traditional IRA and make nondeductible contributions, which aren’t restricted by income, then convert those assets to a Roth IRA. If you have no other traditional IRA assets, the only tax you’ll owe is on the account earnings between the time of the contribution and the conversion."

This is in pretty significant contrast to what I've seen several people post about and talk about with friends, with their CPAs telling them this was verboten, despite several "everyone totally does this and the IRS totally doesn't care" rebuttals.  I've done it the past two years (since I've been above the AGI threshold), as have most of you for the past however-many years.

However, this is one of the first times I've seen a major financial institution recommend their investors do it.  Maybe they leave themselves off the hook by saying you'll owe tax on the earnings between contribution and conversion (which obv should be zero or minimal)?  Or maybe because the converted non-deducted amount is still treated differently than directly contributed Roth amounts, and it's not truly "identical?"

So I guess my question is twofold: one, why do some professionals still recommend against the Backdoor Roth, and two, why the heck is this even necessary in the first place?

[jfoxcpacfp]

DMFA wrote:

This is in pretty significant contrast to what I’ve seen several people post about and talk about with friends, with their CPAs telling them this was verboten, despite several “everyone totally does this and the IRS totally doesn’t care” rebuttals.  I’ve done it the past two years (since I’ve been above the AGI threshold), as have most of you for the past however-many years.

Click to expand...

Yeah, I just posted a response to a question on the Financial Planning Association's website in response to another CFP's question about how back-door Roth IRA's work. I received a private email thanking me for my comments but then condemning my answer in the next sentence and warning me of potentially dire consequences. Maybe the blue-blood professionals just pretend they don't exist? I must have missed that memo.

A little surprised Fidelity is out of the closet, though.

[Craigy]

I have been to both CLE and CPA continuing ed where backdoor roths were presented to hundreds of other professionals.  It's not a secret.

But I do not understand how it's not a violation of the step transaction doctrine.

 

[jfoxcpacfp]

I agree, it's not a secret (at least to some). As far as the step trx, I just think it's not a high priority. I say it all the time, most folks would be amazed at what gets by the IRS. Yes, they have a nasty reputation, but the agents I've known** have done a good job and have to deal with so much crap that it's surprising anything gets caught.

**edited to add (most of them)

[DMFA]

Craigy wrote:

I have been to both CLE and CPA continuing ed where backdoor roths were presented to hundreds of other professionals.  It’s not a secret.

But I do not understand how it’s not a violation of the step transaction doctrine.

 

Click to expand...

Well, it's not completely the same thing as contributing to a Roth.  The additional 5-year rule on money from conversions still applies, even if it is an exception to the early distribution rule.  Maybe that's what exempts it in their minds more than just a "bigger fish to fry" argument.  Here's the doctrine as stated in Commissioner v. Clark, 489 U.S. 726, 738 (1989):

"...interrelated yet formally distinct steps in an integrated transaction may not be considered independently of the overall transaction. By thus linking together all interdependent steps with legal or business significance, rather than taking them in isolation, federal tax liability may be based on a realistic view of the entire transaction."

Then there's the "mutual dependence test," meaning one step is fruitless without the other.  A non-deductible contribution isn't really useless; I mean, I wouldn't do it, but it at least allows for tax-deferred growth although at withdrawal it's taxed worse than LTCGs.  So I'm not fully certain it violates that.

Further involved is an "intent clause," which is more fleshed-out in Long-Term Capital Holdings v United States, 2004, basically saying that if the only reason for one step is to do the next step, then it's bogus.  Sure, I wouldn't make a non-deducted TIRA contribution instead of a taxable.

However, since the money which I converted to Roth isn't the same as money I would have directly contributed to a Roth, vis-a-vis the different 5-year rules and treatment of funds converted vs contributed - hence the federal tax liability is inherently different - then maybe the step doctrine doesn't actually, truly, fully, apply to it.

I'm neither a lawyer nor a tax professional, but that seems like enough of an argument.

[jfoxcpacfp]

Well, you sure sound like a lawyer. Michael Kitces believes the secret is to simply put more time between the steps (naturally). How much time is, of course, a matter of judgment.

[spiritrider]

Yes, and Michael Kites has been refuted by not just one, but two different IRS spokespersons. Once to a financial planning magazine and once recently at a q&a session. In both cases there response was the was no caveat about waiting.

[spiritrider]

Also, there was a recent Court of Appeals, Sixth Circuit ruling. Two weeks ago they ruled that the IRS can not use form over substance to attack the combined use of two perfectly legal tax avoidance actions.

On the first paragraph on page 14 of "Summa Holdings v. Comm'r Internel Revenue", the court specially refers to the backdoor Roth process.

[pulmdoc]

The problem with Kitces' argument is there is simply no way for the IRS to tell how long I waited to make a conversion, short of subpeona'ing my transaction records. That's why I convert ASAP.

[FIREshrink]

spiritrider wrote:

Yes, and Michael Kites has been refuted by not just one, but two different IRS spokespersons. Once to a financial planning magazine and once recently at a q&a session. In both cases there response was the was no caveat about waiting.

Click to expand...

And an IRS spokesperson was quoted in the WSJ five years ago saying the backdoor was permitted, saying, "The law is pretty clear on this issue."

https://www.wsj.com/articles/SB10001424052702304072004577325551162426954

 

[Zaphod]

This kind of thing gets shot down in court all the time. If the individual steps are legal and its to take advantage of a perfectly legal pathway then it doesnt matter. Just see one of the recently linked stories on this forum about millions being put into IRA to make use of rules. It doesnt matter and I wouldnt ever worry about it.

[FIREshrink]

Also the backdoor Roth IRA was described very early on following passage of the law which repealed income limits for Roth conversions (HR 4297 TIPRA 2005) in this WSJ article from May 2006 which described the implications for those earning over $100,000 per year. It was a good time to start making those non-deductible IRA contributions (note the date of the link is updated to March 2007, but the original article was published in May 2006, shortly after the bill was passed):

 

https://www.wsj.com/articles/SB117511735138452332

 

 

[jfoxcpacfp]

I agree that, at this time, there is almost certainly no issue with the step transaction. Even Ed Slott agrees, and I consider Slott and his associates as high an authority (short of the IRS) as you can go. That said, there is still no certainty and no court-tested case to rely on, regardless of what IRS spokespeople say at what point. The best protection we have now, if you have a concern, is length of time between the steps. That is jmo, of course.

[FIREshrink]

On this issue there is no evidence that adding time between the steps makes any difference whatsoever. The IRS is obviously aware of this tactic, has commented on it repeatedly, and has taken no action against it. Accordingly, I do not wait at all between contribution and conversion. I converted our 2006-2010 contributions on January 2 2010, and since then We have contributed on January 1(2) every year and converted on January 3 every year.

Also note Spiritrider's description of the Summa 6th circuit court of appeals ruling, which does explicitly describe the backdoor Roth IRA at the top of page 14. So perhaps the courts have weighed in:

http://www.opn.ca6.uscourts.gov/opinions.pdf/17a0037p-06.pdf

[jfoxcpacfp]

FIREshrink wrote:

On this issue there is no evidence that adding time between the steps makes any difference whatsoever. The IRS is obviously aware of this tactic, has commented on it repeatedly, and has taken no action against it. Accordingly, I do not wait at all between contribution and conversion. I converted our 2006-2010 contributions on January 2 2010, and since then We have contributed on January 1(2) every year and converted on January 3 every year.

Also note Spiritrider’s description of the Summa 6th circuit court of appeals ruling, which does explicitly describe the backdoor Roth IRA at the top of page 14. So perhaps the courts have weighed in:

http://www.opn.ca6.uscourts.gov/opinions.pdf/17a0037p-06.pdf

Click to expand...

It refers, but the case is not about about backdoor Roth conversions. It compares the use of the DISC to Roth as an unintended consequence of the law similar to Roth conversion. There still has not been case law that we can refer to.

I can't believe I had to read this during tax season.