I occasionally receive this question: Can I make a non-deductible IRA contribution, and then shortly after convert the IRA into a Roth IRA? My income is too high for me to make a contribution directly to a Roth IRA.
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According to the rules in place today, you can do this. Here are the applicable rules:
- There is no income limit for an individual to make a non-deductible IRA contribution.
- There is no income limit for an individual to make a Roth Conversion.
- There is no time limit on how long a contribution must be in a traditional IRA before converting it to a Roth IRA.
Essentially this situation provides the individual with an income above the limits to contribute to a Roth IRA with an avenue to accomplish the funding of a Roth IRA. It seems too good to be true. And even though you may feel like it’s flaunting the law, it’s really okay. Here’s why – even though you don’t realize it, the specific rule of law that could apply is called the Step Transaction Doctrine.
Step Transaction Doctrine
Wikipedia defines the step transaction doctrine as follows:
The step transaction doctrine is a judicial doctrine in the United States that combines a series of formally separate steps, resulting in tax treatment as a single integrated event. The doctrine is often used in combination with other doctrines, such as substance over form. The doctrine is applied to prevent tax abuse, such as tax shelters or bailing assets out of a corporation. The step transaction doctrine originated from a common law principle in Gregory v. Helvering, 293 U.S. 465 (1935) that allowed the court to recharacterize a tax-motivated transaction.
The doctrine states that:
- interrelated yet formally distinct steps in an integrated transaction may not be considered independently of the overall transaction. By thus linking together all interdependent steps with legal or business significance, rather than taking them in isolation, federal tax liability may be based on a realistic view of the entire transaction. [2]
There are three tests for applying the step transaction doctrine: (1) a “binding commitment”; (2) a “mutual interdependence” of steps; or (3) the intent of particular result.
Lots of legalese, I know. Let’s see how those three tests would apply to our situation with the non-deductible IRA to Roth Conversion.
Test 1
The Binding Commitment test determines that a particular action has been taken that binds the taxpayer in a commitment to later take another step in the series. Clearly, making a non-deductible IRA contribution does not bind you to take the next step in the series. Since we only have two steps in our series, we only have to apply the test to the first step. Test 1: Pass.
Test 2
The Mutual Interdependence test looks at each step in the series to determine if any of the steps along the line would have been meaningless without the overall series. Again, making a non-deductible IRA contribution can stand on its own without the series and is therefore not meaningless without the series. The same goes for the Roth Conversion – this step could occur without the non-deductible contribution step and is also not meaningless without the series. Test 2: Pass.
Test 3
The Intent test (also known as the “End Result” test) is the most likely to be applied. This test considers the series as a whole to determine if the individual steps were taken solely to achieve the end result, and not simply a group of non-related steps. So – is it likely that the only reason you’ve made the first step (non-deductible IRA contribution) in order to be able to take the second step (Roth IRA conversion) possible so that you can achieve the end result (money in your Roth IRA account).
Application
The IRS has not (to date) raised any qualms against this series of transactions, although it’s possible that they could at some point. In looking at the Intent test, you could see how they would have a case. But it’s really not too likely that the IRS will undertake this position.
Since it’s a given that Roth Conversions are allowed with no restrictions by law, and it’s also a given that non-deductible IRA contributions are allowed with no restrictions by law, it’s unlikely that any law will be written to make changes to these rules in the near future. The only way it could be possible is if there were a holding period requirement within an IRA before converting the account’s holdings to a Roth IRA – and that sounds like a messy bit of law (although nowhere near as messy as some current laws are). I’d say if you are in a position to use this strategy, go ahead and do it. The worst that could happen would be a requirement to de-convert the account back into an IRA.
Keep in mind that making a non-deductible IRA contribution doesn’t automatically allow a no-tax impact conversion to Roth. If you happen to have another IRA (or IRAs) that are deductible in nature, you will have to apply the pro rata tax rules to the conversion.
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