The Tax Cuts and Jobs Act of 2017 (TCJA) has resulted in a temporary reduction in marginal tax rates for most individual taxpayers. However, the TCJA made few changes to retirement plans. For example, federal employees can still contribute the full IRS elective deferral amount (during 2018, a maximum $18,500) to the Thrift Savings Plan (TSP). Those employees over age 49 during 2018 can contribute an extra $6,000 in “catch-up” contributions to the TSP. Federal employees are also eligible to contribute $5,500 ($6,500 if over age 49 during 2018) to some type of Individual Retirement Arrangement (IRA) for 2018.
Two Types of IRAs
There are two types of IRAs – traditional and Roth. Unlike traditional IRAs, Roth IRAs have income limits for contributing. The result is that many high earning federal employees are ineligible to contribute to Roth IRAs. For 2018, married individuals cannot make a Roth IRA contribution if their modified adjusted gross income (MAGI) exceeds $199,000. Single individuals cannot contribute to a Roth IRA during 2018 if their MAGI exceeds $135,000.
In the past – and still true under TCJA – high income individuals have used the “back-door” Roth IRA strategy to move funds into their Roth IRAs. This column discusses how the “back-door” Roth IRA strategy works and how it can benefit high income Federal employees.
What is the Back Door Roth IRA Strategy?
In short, the back-door Roth IRA strategy allows individuals to move funds into a Roth IRA even if they do not qualify to contribute to a Roth IRA because their income exceeds the allowable limits. To do so, these individuals, or if married their spouses, must have earned income (salary, wages or net self-employment income) and be under age 70. No matter the amount of their annual income, they are eligible to make a contribution to a nondeductible traditional IRA – as much as $5,500 ($6,500 if over age 49) during 2018 – and then convert that contribution to a Roth IRA no matter their age, income or tax filing status. Congress and the IRS have said that this is a perfectly legal strategy.
However, there has been talk in recent years that Congress will get rid of this Roth IRA loophole. But elimination of the loophole was not specifically part of the recently passed TCJA. Here is one of several references from the conference report confirming continued use of the back door Roth strategy: “Although an individual with AGI exceeding certain limits is not permitted to make a contribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA.”
5 Advisories for Federal Employees
The following five advisories are for federal employees who intend to move funds to a Roth IRA during 2018 via the back-door strategy:
1. Individuals and/or if married, their spouses, must have earned income during 2018. For married couples, each spouse can perform a back door Roth IRA conversion. The maximum that can be contributed to a traditional IRA for 2018 is $5,500 for individuals younger than 50, or $6,500 for individuals who will be over age 49 as of Dec. 31, 2018.
2. Individuals have until April 16, 2019 to make their 2018 traditional IRA contributions and file IRS Form 8606 (Nondeductible IRAs) with their 2018 Federal income tax returns. They have until they file their 2018 taxes to perform a “back-door” Roth IRA conversion.
3. The back-door Roth IRA conversion will not work if an individual is over age 69. That is because an individual cannot contribute to a traditional IRA starting in the year he or she becomes age 70.5, even if the individual is still working.
4. The back door rule applies to a Roth IRA conversion. This means that all owned traditional IRAs, including SEP and SIMPLE IRAs, are included in the “pro-rata” calculations in order to determine how much of the traditional IRA funds will be taxable upon conversions. What this means is that some of the conversion may be taxable. Federal employees with pre-taxed traditional IRAs and TSP accounts can avoid paying taxes on the conversion by first transferring any pre-tax traditional IRAs into their TSP accounts. They may do so using Form TSP-60 (Request for a Transfer Into the TSP).
Note that the pro-rata traditional IRA calculation works as follows:
Tax-free portion of converted traditional IRA funds equals:
Amount of converted IRA funds times (after-taxed IRA balance)/(total IRA account balance)
Taxable portion of converted traditional IRA funds equals:
Amount of converted IRA funds times (before-taxed IRA account balance)/(total IRA account balance)
The following example illustrates:
Jan is a single Federal employee whose modified adjusted gross income (MAGI) during 2018 will be $200,000, far above the $135,000 MAGI limit for contributing to a Roth IRA. Jan instead contributes $5,500 to her traditional IRA. Because Jan is covered by a pension plan (FERS) and because Jan contributes to the TSP, Jan’s $5,500 contribution to her traditional IRA is nondeductible. Jan will file IRS Form 8606 (Nondeductible IRAs) with her 2018 Federal income tax return reporting the $5,500 traditional IRA contribution. In so doing, Jan is notifying the IRS that the $5,500 IRA contribution was already-taxed money and will be withdrawn from the IRA tax-free.
Jan actually has three IRAs. One IRA is a rollover IRA from a previous employer’s 401(k) plan that is currently worth $50,000. Jan also has a SEP-IRA (also from a previous employer) that is worth $40,000, and she has a $10,000 traditional IRA that consists entirely of after-taxed contributions of $10,000 and no earnings.
Under the pro-rata rule, Jan’s IRA account has a balance of $100,000 ($50,000 plus $40,000 plus $10,000). Of the $100,000, $10,000 is already taxed funds. The other $90,000 is money that has never been taxed. This means that if Jan were to convert the $5,500 traditional IRA contribution to a Roth IRA, only 10 percent of the conversion will be tax-free. The 90 percent of the conversion will be taxable, as shown here:
Tax-free portion: $5,500 times $10,000/$100,000 equals $550
Taxable portion: $5,500 times $90,000/$100,000 equals $4,950
Note that Jan is paying tax on 90 percent of her converted IRA funds even though the $5,500 was previously taxed before it was contributed to the traditional IRA. To avoid paying tax again on 90 percent of her converted IRA funds (in Jan’s case, the $5,500), Jan should have first transferred her $50,000 pre-taxed traditional IRA and her $40,000 SEP IRA into her TSP account using Form TSP-60. If she had done that, then her IRA account would have a total balance of $10,000 consisting of already-taxed funds. In that case, 100 percent of the conversion will be tax-free, as shown here:
Tax-free portion: $5,500 times $10,000/$10,000 equals $5,500
Taxable portion: $5,500 times $0/$10,000 equals $0
5. The funds that end up in the Roth IRA via a “back-door” conversions are considered converted funds and not Roth IRA contributions. As such, individuals under age 59.5 who perform a back-door conversion must wait five years for penalty-free access to those funds. On the other hand, if the funds went in as Roth IRA contributions, the contributions would be accessible immediately, tax- and penalty-free.