REVERSE ROLLOVER: A BRIDGE OVER THE BACKDOOR ROTH TRAPDOORBondBeebe
Scott Reddersen, CPA
Much has been written about the benefits of Roth versus Traditional IRAs, and over the past several
years a popular “backdoor Roth” conversion has made headlines as well. As a refresher, this method allows high-income taxpayers, who are excluded from making direct contributions to Roth IRAs, the ability to make non-deductible contributions to a Traditional IRA, and then immediately convert that amount to a Roth. The net effect, ideally, is minimal tax on any earnings between the date of contribution and the conversion, and years of tax-free growth in a Roth account moving forward. This is especially beneficial for young people who can benefit from growth over time, and can avoid theoretically higher tax rates in the future when distributions may be taken. Furthermore, required minimum distributions do not apply to Roth accounts.
On the surface, there doesn’t appear to be much downside. However, many taxpayers found out the hard way that there can be significant tax implications if other IRAs exist at the time of conversion. This is true because the IRS considers the value of all IRA assets at the time of conversion. For instance, if you had a Traditional IRA account with pre-tax assets of $544,500, made a $5,500 non-deductible IRA contribution and then immediately converted that $5,500 to a Roth account, 99% (or $5,445) would be taxable. In addition to creating an unintended tax liability, it also creates an administrative burden to track the amount on which tax has already been paid.
One solution for those who are still working, and want the benefit of Roth treatment, may be to see if your 401(k) plan allows for a rollover of funds from your Traditional IRA. Often referred to as a “reverse rollover,” this method may help avoid the unintended tax for those with IRAs that have sizeable pre-tax assets. Those assets can be transferred to the 401(k), and there is no pro-rata allocation at the time of future Roth conversions because there are no pre-tax IRA assets left (the only IRA assets are the $5,500 for which no deduction was allowed). There is some complexity involved if the IRA account contains both pre and post-tax contributions because a 401(k) can only be funded with pre-tax dollars.
There may be other benefits to rolling the funds into a 401(k). Depending on the terms of plan, it’s possible you can begin taking distributions from the 401(k) after age 55 if you permanently separate from your employer and leave the assets in that plan. With IRA accounts, you generally can’t access the funds until age 59 ½. Additionally, larger employers may offer better and cheaper investment choices through their 401(k). You may also benefit from greater asset protection from creditors for assets in a 401(k) plan. Last, many plans allow you to borrow from your 401(k), whereas an IRA does not allow for that option.
The pros and cons of a reverse rollover will depend on your individual circumstances, as well as how the 401(k) plan is structured. You should first contact the plan administrator to see if they allow for reverse rollovers, and discuss with your tax and/or financial advisor to learn about how this strategy may benefit you