Tax Loophole – A provision in the laws governing taxation that allows people to reduce their taxes. The term has the connotation of an unintentional omission or obscurity in the law that allows the reduction of tax liability to a point below that intended by the framers of the law.
I am going to have a nerd moment for a minute but bear with me. I can’t stand the improper use of the term tax loophole in articles. I pulled the definition above from Dictionary.com. It seems a little misleading to me. The definition should be rephrased to emphasize the unintentional omission or obscurity section. That is what makes something a loophole. Everything else that allows you to reduce your taxes should just be called tax laws. For instance, one of the first articles that comes up in a google search lists the American Opportunity Credit as the first tax loophole. This is not a loophole! It is a tax credit designed specifically to help those paying for higher education.
The Backdoor Roth strategy is one item that, in my opinion, fits the term of a tax loophole. The law is written to prevent high earners from contributing to a Roth IRA. This strategy is a simple solution for that group. I will cover the details of how it works and who should consider it.
A Backdoor Roth contribution occurs when you make a Nondeductible IRA contribution and then subsequently convert the contribution to a Roth IRA for the same tax year. The key element of a Backdoor Roth is that the traditional IRA contribution is not deductible. The conversion to the Roth IRA means that the money will never be taxed again.
Is it right for you? The most common scenario is young workers who do not have a workplace retirement plan, such as a 401k, but make too much to contribute to a Roth IRA. Young investors who have a long time until retirement can see significant tax-free growth in these accounts. The Backdoor Roth is also beneficial for people who are looking to contribute to a retirement account but can't deduct a traditional IRA contribution. The Roth contribution phase-out limit in 2018 is $135,000 for single filers and $199,000 for married filing joint filers.
Let’s go through the step-by-step process. The ideal scenario is to make your contribution to the traditional IRA and then immediately convert it to a Roth. You can make contributions throughout the tax year, but the conversion must occur before the tax-day deadline. There are tax consequences if you invest the original contribution and then convert a higher amount to the Roth IRA. You also need to file Form 8606 with your tax return for the tax year that you make the contribution. Once you complete the steps properly, your Backdoor Roth contribution will grow and can be distributed tax-free during retirement. This scenario is much more beneficial than if you were to keep the amount in a traditional IRA that would be taxed at ordinary income tax rates when withdrawn in retirement.
You may be thinking that it is pointless for someone earning that much to want to contribute to a Roth IRA because there is no tax benefit in the current year. However, if they can’t deduct a contribution to a Traditional IRA but still want to put more towards retirement, this allows them to receive the future benefits of a Roth.
That covers the basics of a Backdoor Roth. Hopefully, you understand why I think this is one of the most common tax loopholes available. The tax law is written to prevent high income earners from making Roth IRA contributions. This strategy is a quick and simple way around the law. If you need help planning your Backdoor Roth strategy, or you just want to open your own retirement account, contact me for help!
Mike Zeiter, CPA/PFS