White House budget proposal released earlier this year would eliminate several methods used by certain taxpayers to convert after-tax contributions into Roth amounts. Although such a change would likely require congressional action, taxpayers who use or are considering these methods should be mindful of the proposed change.
The “Backdoor” Roth Contribution
Roth IRAs allow lower-income and middle-income taxpayers to make nondeductible contributions and provide tax-free growth. Taxpayers whose income exceeds certain levels are not eligible to make direct contributions to a Roth IRA, however.
Since Roth IRAs were created, the rules have provided for conversion of deductible and nondeductible traditional IRA contributions to Roth amounts. The elimination of the income limits on these conversions in 2010 seemingly permitted high-income taxpayers to establish Roth IRAs through what has come to be known as a “backdoor” Roth IRA.
To establish a Roth IRA using this method, a high-income taxpayer who cannot otherwise fund a Roth IRA makes a nondeductible contribution to a traditional IRA. The taxpayer then converts the traditional IRA to a Roth IRA. If the taxpayer has made deductible contributions or has pre-conversion earnings on nondeductible contributions, the conversion will include a pro rata taxable amount. This tax hit might discourage some taxpayers from converting their traditional IRAs. However, if the taxpayer has no pre-tax amounts in her IRAs (i.e., has not made any deductible contributions to traditional IRAs and has no earnings on nondeductible contributions), the conversion is tax-free.
Rollovers of After-Tax Amounts
A strategy similar to the backdoor Roth IRA is a rollover of after-tax contributions from an employer-sponsored plan to a Roth IRA. In IRS Notice 2009-68, the IRS suggested that a taxpayer generally could not simultaneously roll over after-tax contributions to a Roth IRA and roll over earnings on those contributions to a traditional IRA. This restriction meant that 401(k) plan participants with earnings on after-tax contributions, like IRA owners with pre-tax amounts in traditional IRAs, might be reluctant convert those contributions because of the immediate tax hit on the earnings. However, after receiving comments requesting that it change the position articulated in IRS Notice 2009-68, the IRS did just that. In IRS Notice 2014-54, the IRS concluded that taxpayers can roll over after-tax contributions to a Roth IRA while continuing to defer tax on the pre-conversion earnings from those contributions by simultaneously rolling over the earnings to a traditional IRA. See the IRS’s explanation of its new position.
In-Plan Conversions of After-Tax Amounts
Another mechanism for Roth conversion of after-tax contributions is the in-plan Roth conversion. The IRS explained in IRS Notice 2010-84, “If the distributee rolls over the payment to a designated Roth account in the plan, the amount of the payment rolled over (reduced by any after-tax amounts directly rolled over) will be taxed.” (Emphasis added). The elimination of this conversion method may be most significant for employers sponsoring 401(k) plans, as it is the only method that must be permitted by plan documents.
Prohibition of Conversions
Based on the Treasury’s explanation of the budget proposal, it appears that these conversion methods would be eliminated through a prohibition on conversion of after-tax contributions (rather than limited, for example, through income restrictions).