Roth Conversions - IRS Audit? - Ed Slott and Company, LLC

Submitted by Michael Sicuranza on Tue, 2014-10-21 18:11

I was on a conference call the other day and the CPA who was running it made the comment that non-deductible IRA contributions that are instantly converted to a Roth are being flagged by the IRS and being rejected. Is this the case? Or are the risks overblown?

Mike Sicuranza

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Permalink Submitted by Alan - IRA critic on Tue, 2014-10-21 20:12

Well, Robert Keebler is not your ordinary CPA. He is recognized as one of the top IRA experts in the US. That said, I think that he and Michael Kitces have both written articles reflecting concern that the IRS at some point might target this strategy as an illegal step transaction. A step transaction is a series of transactions the are entirely legal under the tax code, but end up circumventing the intent of Congress or the IRS. Since Congress did not intend to have high income taxpayers making regular Roth contributions, the thinking was that the IRS might take action to limit this strategy. Finally, the popular moniker for this strategy is “back door” Roth, and the IRS cannot be happy with that reference.
Notwithstanding the above, all the added portability accorded retirement accounts in the last 15 years has created a series of issues. Last month, the IRS reversed course and will now allow taxpayers to isolate their basis in splitting rollovers to different types of IRA accounts (Notice 2014-54). This was a complete reversal with respect to their Notice 2009-68 just 5 years ago which intended to make pro rating of basis a requirement of these rollovers. In fact, the IRS likely concluded that there was no practical way of managing their original intent, and I think that the back door Roth is similar in certain respects. Finally, the tax revenue from conversions is considerable and the IRS does not really want to restrict them. Tax free conversions are very small in relation to the income received on taxable conversions, so I expect the IRS will just have to live with this. I do not know what they could do other than to put a time limit on conversions following a contribution, but that would just present more complexity and red tape.
If this ever becomes an issue, it will get immediate attention on these forums and in the financial press. In the unlikely event the IRS does decide to restrict this strategy, is will only be on future transactions. There is no practical way for them to retroactively take actions on completed conversions.

Permalink Submitted by Bruce Steiner on Tue, 2014-10-21 21:21

Bob and I discussed this a couple of months ago. He said that someone else had told him about a case where a return was audited for some other reason, and the IRS agent raised the step transaction issue, and wanted the Roth IRA to be recharacterized back to a traditional IRA.

I don’t think you can generalize from one anecdotal case. Even if this were to happen, and you had to recharacterize the Roth IRA back to a traditional IRA, you could still convert it again.

I could understand it in principle if the IRS were to require a 30-day waiting period, analogous to the wash sale rules, or the waiting period after recharacterizing before you can convert again. However, the amount involved in this isn’t meaningful, since annual contributions to IRAs are limited to $5,500 ($6,500 for taxpayers over age 50). So I don’t think will be a priority for the IRS.