Power and Potential of Roth Conversion

US tax code—complicated and convoluted even for the best legal minds—can be simplistic and straightforward sometimes; a retirement plan is either funded by already taxed funds or not taxed (i.e. pre-tax) funds. Roth IRA, according to its legislative design, is funded with already taxed funds and therefore grows and accumulates wealth tax-free—for example, in the case of Silicon Valley entrepreneur Peter Thiel (as reported on https://www.propublica.org) $2,000 worth of startup stocks accumulated to $5 billion, capital gain tax free (if paid or distributed as a “qualified distribution… made on or after the date on which the individual attains age 59½”).

For those fastidious on official, statutory language, the magic power of Roth lies here:

(1) EXCLUSION

Any qualified distribution from a Roth IRA shall not be includible in gross income.

(2) QUALIFIED DISTRIBUTION

(A) In General

The term “qualified distribution” means as any payment or distribution—

(i) made on or after the date on which the individual attains age 59½,

(ii) made to a beneficiary (or to the estate of the individual) on or after the death of the individual,

(iii) attributable to the individual’s being disabled (within the meaning of section 72(m)(7)), or

(iv) which is a qualified special purpose distribution.

IRC §408A(d) (DISTRIBUTION RULES)

Again, the statutory design, essentially, is to waive taxation on future gains and account asset appreciations, in exchange for the US government’s inability to waive retirement contribution deduction allowance at the time of codifying Roth IRA, and also as a simple logic result of the conceptual dichotomy of taxed v. untaxed source funding.

Annual contribution amounts are limited by gross income; however, with the ready availability of Roth IRA conversion/back-door Roth, the tax waiver is estimated to cost US Treasury dearly in the coming decades. Now, the Biden Build Back Better (BBB) Legislative Plan have nonetheless dropped provisions to eliminate Roth IRA conversions and back-door Roths (along with provisions that would reduce estate and gift tax exemptions and deny the stepped-up basis on inheritances); instead, the Plan calls for 5% surtax on income above $10 million 8% surtax on income above $25 million, in addition to elevated income taxes (for both ordinary income and capital gain).

As such, the Roth conversion and § 1014(a) stepped-up basis now apparently survive the most severe political and legislative challenges known in recent US history (​considering, among other things, the partisan and ideological struggle quite vividly illustrated by January 6th Capitol attack, the Democrats’ crescendoing backlash against 2017 Trump tax cuts and billionaire class capital gain tax “loopholes,” and more practically the current desperate need to fiscally fund BBB Plan​). Taxpayers anticipating being in higher tax brackets in the future, estates and professional wealth planners would be amiss not to study the tax and planning benefits of Roth IRA.

This article highlights key constructs, tax code provisions and regulations on “Backdoor Roth Conversion.”

By getting around Code §408A(d)(3) income limitation (as adjusted for inflation, income limitation at $140,000, or $208,000 for married couples filing a joint tax return, Fiscal Year 2020) on contribution eligibility, the Roth conversion basically makes the powerful retirement and estate tax planning vehicle generally available. In addition to allowing tax-free growth and withdrawal, Roth IRA also waives statutory requirement on minimum distributions (RMD), as compared to traditional IRA plans.

As the law stands, the so-called backdoor Roth conversion basically converts a traditional non-Roth account and to a Roth IRA. To get around income limitation, higher earners may simply fund a pre-tax IRA, and convert it to a Roth IRA. While withdrawal from the traditional IRA is taxable, tax deduction for those contributions beyond a certain income might not be available. See,

The other caveat to the entire backdoor Roth conversion enterprise, is that it won’t work well for people with pre-tax contributions in IRA accounts at time of the Roth conversion. The IRS Roth conversion rules call for pro rata computing  of the portion of funds subject to (as IRA distribution, taxed as ordinary income) tax. Basically, the IRS rule assumes newly contributed, after-tax funds (to be converted) carry the pre-tax v. taxed funding attributes proportionally; the pro rata portion of funds not taxable as traditional retirement account distribution = amount to be converted * (portion of pre-tax contributions/total amounts of IRA account balances). This is the confusing and seemingly convoluted computation issue taxpayers need to figure when converting to Roth IRA, namely, contributing and converting the same amount to Roth IRA when they have other traditional IRA, or SIMPLE IRA account balances.

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