Possible Challenge to Backdoor Roth Contributions?
By Kaye A. Thomas
Current as of February 14, 2015
This article is adapted from our book, Go Roth!
Some tax professionals have raised the possibility that the IRS could challenge the tax treatment of the backdoor Roth technique. Their concern is that the IRS may collapse the two transactions (a contribution to a traditional IRA followed by a conversion) into one (a contribution to a Roth, which is not permitted because of the income limit). In this case you could incur a penalty for making an excess contribution to the Roth. Some have suggested creating a delay, perhaps as long as a year, between the contribution and the conversion, as a way to reduce this risk.
My assessment: there is no cause for concern, for several reasons.
- It would have been obvious to the taxwriters in Congress that they were creating this opportunity when they eliminated the income limit on conversions, and they chose not to block it. As a result, there is a fair argument to be made that Congress intentionally created this opportunity.
- Tens of thousands of taxpayers use this technique each year. Leading mutual fund provider Vanguard Group recommends the technique and reports processing some $100 million in backdoor Roth contributions in 2013.
- The IRS has known about this technique since before the law eliminating the income limit on conversions took effect, and has not lifted a finger to stop it.
I don’t dispute the existence of a legal doctrine that creates the theoretical possibility of a legal challenge to the backdoor Roth technique. Yet there is no realistic possibility that the IRS will pursue a retroactive challenge to a transaction it has knowingly permitted to flourish over a period of many years.
President Obama’s budget proposal for fiscal 2016 includes a provision that would prevent after-tax dollars in a traditional retirement account from being converted to a Roth. This provision would have broad consequences, including doing away with the backdoor Roth contribution. It would be prospective only, taking effect in 2016.
This proposal seems unlikely to succeed in today’s Congress. It’s more likely that Congress will remove the income limitation on Roth IRA contributions, doing away with the need to take these steps. In any event, any change that would block these transactions will be prospective only. People who have already done backdoor contributions will not be penalized. If you’re one of the many for whom this transaction makes sense, you should proceed without concern about a possible legal challenge.
As a reminder, I do recommend making sure the two transactions are distinct: obtain confirmation that the contribution to the traditional IRA has been documented before proceeding with the conversion, and avoid doing both transactions on the same day.