Help Clients Boost Sav­ings

Clients can in­crease their IRA re­tire­ment sav­ings by thou­sands with this strat­egy.

Financial Planning - - CONTENTS - BY KIMBERLY FOSS

Clients can in­crease their IRA re­tire­ment sav­ings by thou­sands with this strat­egy.

If you have high-net-worth clients who are look­ing for ways to put away more in their re­tire­ment ac­counts, it may be time to show them how to su­per­size their re­tire­ment ac­counts with the mega-back­door Roth IRA con­tri­bu­tion strat­egy.

When Congress raised the in­come lim­its on el­i­gi­bil­ity for Roth con­ver­sions in 2010, higher-in­come tax­pay­ers were able to con­trib­ute to a nond­e­ductible tra­di­tional IRA and then con­vert it to a Roth IRA a short time there­after.

For mar­ried cou­ples fil­ing jointly whose in­come is $199,000 or greater in 2018, con­tri­bu­tions to a tra­di­tional IRA are not de­ductible, and they’re dis­qual­i­fied from con­tribut­ing to a Roth IRA.

How­ever, a high-in­come in­di­vid­ual might make a nond­e­ductible con­tri­bu­tion to a tra­di­tional IRA and sub­se­quently con­vert it to a Roth ac­count in or­der to make tax­ad­van­taged with­drawals from the ac­count in re­tire­ment.

Their abil­ity to make con­tri­bu­tions to a Roth IRA is cur­tailed, but not their abil­ity to con­vert an ex­ist­ing tra­di­tional ac­count to a Roth ac­count. (The 2018 tax law ended the abil­ity to re­verse a Roth con­ver­sion by con­vert­ing it back into a tra­di­tional ac­count.)

Some clients run into a com­pli­ca­tion from the IRS ag­gre­ga­tion rule while ex­e­cut­ing this strat­egy, though. IRC 408(d)(2) stip­u­lates that “all in­di­vid­ual re­tire­ment plans shall be treated as one con­tract” and that “all dis­tri­bu­tions dur­ing any tax­able year shall be treated as one dis­tri­bu­tion.”

This means that if a client had any tra­di­tional IRA ac­counts in place at the time the Roth con­ver­sion was per­formed, the dis­tri­bu­tions from the con­verted ac­counts would be treated the same way as the dis­tri­bu­tions from tra­di­tional ac­counts, since

The cru­cial step for the tax court is to es­tab­lish the client’s in­tent to by­pass the in­come lim­its on Roth con­tri­bu­tions.

the IRS rule ag­gre­gates all ac­counts for tax pur­poses.

For­tu­nately, though, 401(k) ac­counts are not sub­ject to the ag­gre­ga­tion rule. This means that any as­sets held in such em­ployer-spon­sored plans will not fall afoul of IRC 408(d)(2).

In fact, clients may roll over funds from tra­di­tional IRA ac­counts into 401(k) ac­counts and thus en­sure the ag­gre­ga­tion rule will not ap­ply to sub­se­quent dis­tri­bu­tions from those as­sets.

This as­sumes, of course, that the client’s 401(k) plan per­mits rollover con­tri­bu­tions from out­side tax-qual­i­fied ac­counts.

Now the good part. As­sume you have a high-net­worth client who is highly fo­cused on both sav­ing for re­tire­ment and lever­ag­ing tax-ad­van­taged growth in her in­vested as­sets.

She has al­ready made the max­i­mum al­low­able con­tri­bu­tion to her other tax-qual­i­fied plans, in­clud­ing her health sav­ings ac­count, her IRAS and her reg­u­lar 401(k) con­tri­bu­tion. But she wants to do more. What do you tell her?

You sug­gest that the client make a non-roth after-tax con­tri­bu­tion to her 401(k). You will need to help her check her plan docu-

ments to make sure that the plan al­lows such con­tri­bu­tions.

Pro­vided her plan doc­u­ment was drafted to per­mit th­ese con­tri­bu­tions, she can con­trib­ute up to the max­i­mum al­lowed for all types of con­tri­bu­tions (em­ployee con­tri­bu­tions, em­ployer con­tri­bu­tions and non-roth after-tax con­tri­bu­tions). For 2018, the max­i­mum al­lowed for all con­tri­bu­tions is $55,000.

So, sup­pos­ing that your client’s em­ployer (likely the client her­self) had con­trib­uted $10,000 to her 401(k), she would be able to put in an­other $26,500 ($55,000 - $10,000 - $18,500).

Her con­tri­bu­tion is nond­e­ductible, but it may be with­drawn tax-free. It will ac­cu­mu­late in a tax-free en­vi­ron­ment, and when the earn­ings are with­drawn, they would be taxed as or­di­nary in­come. Un­less, of course, you ad­vise your client to take the next step.

Once the client has con­trib­uted the after-tax funds to the 401(k), she can roll them over into a Roth IRA. The rollover is a tax-free event, and be­cause the as­sets are now in a Roth IRA, both the con­tri­bu­tion and the sub­se­quent earn­ings may be with­drawn tax-free.

The only por­tion of any dis­tri­bu­tions that would be tax­able is the amount earned by the as­sets while they were in the 401(k). Ideally, the rollover took place rel­a­tively soon after the 401(k) con­tri­bu­tion, and as such, any earn­ings would be neg­li­gi­ble.

There’s a ma­jor caveat I must men­tion: The IRS step-trans­ac­tion doc­trine, which orig­i­nated in 1935, holds that sep­a­rate steps in a chain of trans­ac­tions that have no in­her­ent busi­ness pur­pose may be treated as a sin­gle tax event.

In other words, if the rollover hap­pens too soon after the non-roth con­tri­bu­tion, the Tax Court may rule that the in­tent was to make an oth­er­wise im­per­mis­si­ble Roth con­tri­bu­tion, which might be dis­al­lowed. This would likely re­sult in a 6% penalty for ex­cess con­tri­bu­tions to a qual­i­fied plan.

Ad­vi­sors take dif­fer­ent po­si­tions on the best way to avoid trig­ger­ing that is­sue. The most con­ser­va­tive plan­ners ad­vise wait­ing a full year be­fore rolling over the funds from the 401(k) to the Roth IRA. Oth­ers sug­gest wait­ing a month (a typ­i­cal ac­count state­ment cy­cle) to make the move.

If a rollover hap­pens too soon after a non-roth con­tri­bu­tion, a court might dis­al­low it, which could re­sult in a 6% penalty for ex­cess con­tri­bu­tions to a qual­i­fied plan.

But per­haps the most im­por­tant mea­sure in avoid­ing the ap­pli­ca­tion of the step-trans­ac­tion doc­trine is to avoid red-flag terms, such as “back­door Roth” or “Roth con­ver­sion,” in your writ­ten com­mu­ni­ca­tions with the client.

The cru­cial step for the Tax Court is to es­tab­lish the client’s in­tent to by­pass the in­come lim­its on Roth con­tri­bu­tions.

By avoid­ing those terms in your com­mu­ni­ca­tions with your client, you won’t be as­sist­ing the IRS in mak­ing its case, should any­one be­come cu­ri­ous about your client’s Roth as­sets.

Es­pe­cially for non-cpa prac­ti­tion­ers, whose records are typ­i­cally not pro­tected by ad­vi­sor-client priv­i­lege, it is vi­tal to be care­ful what you say and what you write.

On the other hand, some ex­perts be­lieve the IRS is un­likely to come after tax­pay­ers who have done back­door Roth con­ver­sions.

For ex­am­ple, Jef­frey Levine says he was un­able to find a sin­gle case where the IRS has faulted a con­ver­sion by ap­peal­ing to the step-trans­ac­tion doc­trine.

In sum­mary, here are a few caveats and tips for im­ple­ment­ing this strat­egy.

• This only works for clients with sig­nif­i­cant re­sources and in­come who have al­ready maxed out con­tri­bu­tions to their other re­tire­ment ac­counts.

• The client’s 401(k) plan must al­low for non-roth, after-tax con­tri­bu­tions to the plan.

• You (per­haps in con­cert with the client’s tax ad­vi­sor) will need to help the client carry out the strat­egy in a way that avoids the IRS ag­gre­ga­tion rule and pro­hi­bi­tion on step trans­ac­tions.

• Don’t for­get the HSA. when max­ing out an­nual con­tri­bu­tions to tax-qual­i­fied plans, in­clud­ing the 401(k).

• Us­ing the 401(k) avoids the IRS ag­gre­ga­tion rule.

• When pos­si­ble, ad­vise self-em­ployed clients to de­sign their 401(k) plans to per­mit non-roth em­ployee con­tri­bu­tions.

• Take care to avoid red-flag lan­guage in your com­mu­ni­ca­tions with your client.

• It’s smart to al­low some time to elapse be­fore the rollover. Just re­mem­ber that any ac­crued earn­ings be­fore the rollover will be taxed upon with­drawal.

When im­ple­mented prop­erly, the mega-back­door Roth strat­egy can help your high-net-worth clients set aside tens of thou­sands of ex­tra dol­lars each year. Th­ese as­sets will ac­cu­mu­late tax-free and pro­vide non­tax­able in­come in re­tire­ment.

This back door can lead to huge ben­e­fits both for your client and for the ad­vis­ing re­la­tion­ship. FP

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