Legal justification of the backdoor & mega backdoor Roth

Introduction

This document summarizes statutory provisions of the Internal Revenue Code in conjunction with IRS guidance pertaining to the popular “backdoor Roth” and “mega backdoor Roth” strategies. These strategies allow for fuller utilization of the tax-privileged retirement savings account known as the Roth IRA.

The “backdoor Roth” strategy

Overview

Contributions may annually be made into either a traditional or Roth IRA up to a certain limitation on the total of annual contributions.1 Typically, contributions to a traditional IRA are tax-deductible (“pre-tax”),2 and allocation of funds between traditional and Roth IRAs up to the total limitation may be performed in any proportion desired.3 However, as modified adjusted gross income increases, the proportion of contributions to traditional IRAs which are tax-deductible and the total annual limitation of contributions to Roth IRAs both phase out to zero.4 For example, in 2019, the phaseouts for single filers respectively begin at $64,000 and $122,000 for traditional and Roth IRAs.5

Non-deductible contributions. Notably, non-deductible (“after-tax”) contributions can be made into a traditional IRA up to the general limitation of total IRA contributions irrespective of income.6 Additionally rollovers of traditional IRAs may be performed into Roth IRAs irrespective of income.7 Performing these two steps in sequence constitutes the “backdoor Roth” strategy (BRS).

Prior pre-tax traditional IRAs

A complication arises when executing the BRS with existing pre-tax contributions in a traditional IRA. This may arise as a result of tax-deferred contributions in the past, rollovers from the pre-tax portions of 401(k) plans, or from execution of the MBRS such that pre-tax earnings on after-tax contributions are rolled over into a traditional IRA.

Notably, the tax consequences of distributions from traditional IRAs must be calculated as though all traditional IRAs were aggregated together into a single account.8 To illustrate, suppose $2,000 of regular, tax-deductible contributions have been made into a traditional IRA. Subsequently, the BRS is attempted by executing a $6,000 after-tax contribution into a different traditional IRA. If $6,000 is subsequently distributed from the traditional IRA into a Roth IRA, it will constitute a distribution of $1,500 in pre-tax funds and $4,500 in after-tax funds into the Roth IRA, with ordinary income taxes assessed on the $1,500 of pre-tax funds. This occurs because the two traditional IRAs are aggregated together for the purpose of the distribution and the distribution is therefore subject to pro-rata allocation between the $2,000 of pre-tax funds and the $6,000 of after-tax contributions.

In this circumstance, if the pre-tax funds in preexisting traditional IRA(s) are rolled over into a 401(k) plan, they will no longer be subject to the aggregation rule.9 If planning on future execution of the MBRS, it is advisable to select as the rollover destination the account in your 401(k) plan in which elective deferrals are held.

Summary of procedure

  1. Roll over any preexisting traditional IRAs with pre-tax balances into a 401(k).
  2. Perform a regular contribution into a traditional IRA.
  3. Request a rollover of the funds in the traditional IRA into a Roth IRA.
  4. When preparing your tax return, fill out Form 8606. Report any taxable gains incurred in the traditional IRA if such gains were rolled over into the Roth IRA along with the original contributions.

Withdrawal of contributions

Whereas regular contributions (excluding earnings) to a Roth IRA may be withdrawn at any time without tax or penalty, contributions via the BRS are conversion contributions and thus subject to a 5-taxable-year waiting period before tax- and penalty-free withdrawal (again excluding earnings).10 Consequently, whenever possible, regular contributions should be made into a Roth IRA instead of conversion contributions through the BRS into the Roth IRA.

The “mega backdoor Roth” strategy

Overview

An annual limitation exists on “traditional” contributions to 401(k) plans, which are deducted from an employee’s paycheck by the employer and not subject to income taxes.11 These are referred to as elective deferrals and may be designated as either “traditional” or “Roth.” Additionally, 401(k) plans are subject to a strictly greater limit on the sum of all annual contributions,12 In 2019, these limitations were $19,000 and $56,000 respectively.13 As such, even when an individual meets the limitation on elective deferrals, there is typically still considerable room left over for employee contributions (referred to colloquially as “after-tax contributions”). It is possible to perform a distribution of after-tax contributions (and earnings thereon) into a Roth IRA while leaving elective deferrals untouched.14

After-tax contributions. 401(k) plan providers may allow after-tax contributions to be made into a separate account.15 Separate after-tax accounts must record earnings and losses specific to the after-tax contributions without commingling them with other funds such as elective deferrals.16 Additionally, in situations where this separate accounting is performed, plan providers may offer participants the option of choosing from which account a distribution is performed.17 Earnings made within the after-tax account are considered pre-tax balances within the account.18 When a distribution is made from an after-tax account, the distributed funds are taken proportionally from the pre-tax and after-tax balances in the account.19

Conversions. Although distributions of elective deferrals from 401(k) plans are only generally allowed after age 59.5,20 there appears to be no corresponding limitation on distributions of after-tax contributions.21 A distribution from a 401(k) plan, necessarily including distributions from after-tax accounts within a 401(k) plan, may be rolled over directly to a Roth IRA, with taxes owed on the earnings.22 Additionally, instead of rolling over the entire balance into a Roth IRA, some or all of the pre-tax earnings can be rolled over to a traditional IRA and the after-tax contributions can be rolled over to a Roth IRA in a single distribution.23. Either of these options constitute complete execution of the “mega backdoor Roth” strategy (MBRS).

Summary of procedure

  1. Verify that your 401(k) plan supports after-tax contributions into a separate account as well as in-service distributions of the after-tax account such that the pre-tax earnings and after-tax contributions are respectively allocated to a traditional IRA and a Roth IRA.
  2. Make after-tax contributions to your 401(k) plan into the separately accounted after-tax account.
  3. Contact your plan provider and request a distribution of part or all of the after-tax account balance. According to your preference, specify some or all of the pre-tax balance as designated for rollover into a traditional IRA, and specify the after-tax balance for rollover into a Roth IRA.
  4. When preparing your tax return, fill out an additional copy of Form 1099-R. Report any taxable gains incurred in the after-tax 401(k) account which were subsequently rolled over into a Roth IRA.

There is no statutory limitation on the frequency with which the above steps may be performed.

Withdrawal of contributions

Since the MBRS executes a conversion contribution into a Roth IRA, such contributions, like those performed with the BRS, are subject to a 5-year limitation on penalty-free withdrawal.

Plan testing

In general, 401(k) plans are subject to two nondiscrimination tests known as the actual contribution percentage test (“ACP test”) and the actual deferral percentage test (“ADP test”), as well as the top-heavy test, which impose penalties or require the reversal of plan contributions if high-income employees contribute in excess to their 401(k) plans. Although plans can be designed with an employer match such that they are exempt from all three tests (“safe harbor 401(k)s”), the presence of after-tax contributions into a 401(k) means such an exemption does not fully apply to the ACP and top-heavy tests.

Terminology. The ADP and ACP tests classify employees as highly compensated (HCEs) or as non-highly compensated (NHCEs). HCEs consist of those who (1) in a given year or in the year prior owned more than 5% of the company at any point in time or (2) or who in the year prior had compensation greater than an annually increasing limit (e.g., $125,000 if the preceding year is 2019) and, if the employer chooses to exercise this option, was in the top 20% of employees ranked by compensation in the prior year.24 All other employees are NHCEs. Similarly, the top-heavy test examines the contributions of “key employees,” which are those who, for any given year, (1) has compensation for that year exceeding an annually increased limit ($180,000 in 2009), (2) owns more than 5% of the company, or (3) owns more than 1% of the company and has compensation for that year greater exceeding $150,000.25

Testing conditions. Let an employee’s “contribution percentage” for a given year denote the ratio of their after-tax contributions plus matching contributions to their compensation for the year. A plan meets the ACP test in a given year if, for either the given year or the year prior according to the employer’s choice, the average HCE contribution percentage does not exceed the greater of (1) 125% of the NHCE average contribution percentage or (2) the lesser of (a) 200% of the NHCE average contribution percentage (b) the NHCE average contribution percentage plus 2 percentage points.26 A plan meets the ADP test if it satisfies the same conditions as in the ACP test when contribution percentages are calculated instead with elective deferrals.27 Finally, a plan meets the top-heavy test in a given year when the total value of the accounts of key employees does not exceed 60% of the total value of all accounts plan on the testing date, which is the last day of the prior year (or the given year for newly established plans).28 For the top-heavy test, account value is calculated after various modifications, such as adding back all in-service distributions in the five-year period ending on the testing date and subtracting rollovers into the plan from unrelated sources (such as traditional IRAs).29

ACP and ADP details. For the ACP and ADP tests, limits are imposed on HCE contributions in a given year based on NHCE contributions either in the current year or the prior year. For the calculation of such limits, an employer can always switch from using the prior year to using the current year,30 but cannot switch from using the current year to using the prior year if the preceding five years (or up to the creation of the plan) were not all tested using the current year method.31 If a plan satisfies the safe harbor exemptions for either test (described below), it is considered to be using the current year testing method.32 An employer does not have to use the same testing method (current year or prior year) for both the ACP and ADP tests.33 However, once a nonelective or matching contribution is used to satisfy any ACP or ADP test or a safe harbor requirement, it can no longer be used o satisfy any other ACP or ADP test (including future tests).34

Penalties. If a 401(k) plan fails either the ACP or ADP tests, the employer must distribute excess contributions to HCEs,35 contribute into the 401(k) plans of NHCEs,36 or a combination of both until the plan satisfies both tests. Moreover, if a 401(k) plan fails the top-heavy test, the employer must make additional contributions to each non-key employee’s 401(k) plan so that employer contributions to each non-key employee’s 401(k), including preexisting matching contributions on elective deferrals, constitute the lower of (1) 3% of each employee’s salary or (2) a percentage of each employee’s salary equal to the greatest contribution-to-salary ratio among all key employees.37

Safe harbor exemptions. 401(k) plans are typically exempt from ADP testing if either of the following conditions are met along with appropriate notice requirements: (1) the employer contributes 3% of each employee’s salary into their 401(k) regardless of the extent to which the employee contributes elective deferrals, or (2) all of the following: (a) the employer matches at least (a) 100% of an employee’s elective deferrals up to the first 3% of their salary and at least 50% of such deferrals up to the next 2% of their salary, (b) the matching rate for HCEs cannot be higher than for NHCEs at any rate of elective deferral with respect to salary, and (c) the matching percentages cannot decrease with the deferral rate.38 Additionally, 401(k) plans are exempt from ACP testing if further notice requirements are met, along with all of the following: (1) the plan satisfies conditions for exemption from ADP testing, (2) matching contributions are not made for elective deferrals past 6% of an employee’s salary, and (3) no after-tax contributions are made by the employee.39 Regardless of whether or not a 401(k) plan satisfies the above requirements from exemption from ACP testing, it must meet the ACP test applied to after-tax contributions,40 either with or without matching contributions.41 Finally, 401(k) plans are exempt from top-heavy testing if they are fully exempt from all ADP and ACP testing,42 meaning that if after-tax contributions are made, then top-heavy testing must occur.

Legitimacy

Case law relevant to the (M)BRS is reviewed.

Facts of Summa. In 2015, the Tax Court ruled in Summa Holdings et al. v. Commissioner (Summa I) that certain shareholders of Summa Holdings, Inc. (Summa) were liable for excise taxes owing to excess contributions to Roth IRAs.43 The Benenson family owned Summa, a Delaware C corporation which itself owned several manufacturing subsidiaries. In 2001, James III and Clement of the Benenson family each opened a Roth IRA and made regular contributions of $3,500. In 2002, JC Export, a separate Delaware corporation controlled by the Benenson family, filed an election to be treated as a DISC (domestic international sales corporation).44 Subsequently, each IRA was used to purchase 1,500 shares of JC Export, and the shares were immediately transferred to JC Export Holding, Inc. (JC Holding).45 Also in 2002, subsidiaries of Summa entered into agreements with JC Export pursuant to which the subsidiaries made payments totaling approximately $2.2 million in four installments over the course of 2008. Immediately following each payment, JC Export transferred the entire amount of the payment to JC Holding. JC Holding then transferred as the entire amount of the payment to the two IRAs with the exception of withholdings for the unrelated business income tax of approximately 33%. These dividends could then be invested within the Roth IRA without incurring taxes on future growth.

Argument of the Commissioner. The substance-over-form doctrine is a well-established common law principle which allows for recharacterization of transactions to more accurately represent economic reality when the form of a transaction is contrary to the intent of the statutory provisions which allow for tax benefits to be claimed in association.46 The Commissioner claimed that the substance-over-form doctrine allowed for recharacterizations of the payments from subsidiaries of Summa to JC Export as “dividends to Summa’s shareholders followed by contributions …into the Benenson Roth IRAs,” and determined an “excise tax deficiency” for James III and Clement because “the contriutions to the Roth IRAs [exceeded] the annual contribution limits for Roth IRAs,” as well as income tax against Summa Holdings by “disallowing the DISC commission deductions that Summa claimed for the payments it made [to JC Export].”47 In Summa I, the Commissioner argued to the Tax Court that “[the Benenson family] had no nontax business purpose for establishing the Benenson Roth IRAs, JC Export, and JC Holding, and petitioners did not [receive] any nontax economic benefits from the [recharacterized] transaction.”48 The Commissioner later clarified further to the Sixth Circuit that “the ‘critical point’ of his argument is that the tax benefits Summa Holdings has enjoyed were ‘unintended both by the Roth IRA and DISC provisions.’ ”49 The Court ruled in favor of the Commissioner.

Relevance to (M)BRS. The application of the substance-over-form doctrine in Summa I and II clearly indicate the legal argument through which the IRS would seek to recharacterize an execution of the (M)BRS as a direct contribution to a Roth IRA—namely, by claiming that there are no nontax business purposes for execution of the (M)BRS, and that the (M)BRS yields tax benefits contrary to Congressional intent. Although popular tax guidance typically refers to the step transaction doctrine as the basis of enforcement action against the (M)BRS,50 the step transaction doctrine is more accurately understood as a constituent part of the overall substance-over-form doctrine,51 meaning that it suffices to consider the latter.

Appellate rulings. All taxpayers in Summa I appealed, resulting in rulings against the Commissioner in all of the Sixth Circuit (Summa Holdings v. Commissioner (2018); Summa II),52 the First Circuit (Benenson v. Commissioner; Benenson I),53 and the Second Circuit (Benenson v. Commissioner; Benenson II).54 These rulings, although not binding on the Tax Court outside of their respective Circuit, provide a legal basis strongly supporting the legitimacy of the (M)BRS. In particular, the Court ruled Benenson I that the substance-over-form doctrine is a “tool of statutory interpretation,” and since the transactions of the Benenson family do not “violate the plain intent of the relevant statues,” the doctrine cannot be used to justify recharacterization.55 That is to say, the economic substance of the statues authorizing the usage of DISCs and Roth IRAs in the manner of the Benenson family is tax avoidance, and so the substance-over-form doctrine cannot be used to claim that the tax-avoidant actions of the Benenson family have a conflict between their form and economic substance. Additionally, in Summa II, the Commissioner claimed that the substance-over-form doctrine empowered him with the broad power to recharacterize lower-tax paths to an end as an otherwise equivalent higher-tax paths to the same end, irrespective of the economic substance of the lower-tax path or its relation to the Code, because the higher-tax path may simply be asserted by the Commissioner as the “real” version of the transaction.56 The Court thoroughly rejected this argument, first on the basis that “only a parody of a purpose-based approach to interpretation, unanchored to statutory text, could justify a one-way use of this power,”57 and second because even if one accepts an argument that the overarching purpose of the Code is to maximize revenue, thereby empowering the Commissioner to perform such one-way uses, it is nevertheless the case that “[t]he Commissioner cannot place ad hoc limits on [entitites for which the purpose is tax avoidance] by invoking a statutory purpose (maximizing revenue) that has little relevance to the text-driven function of these portions of the Code (minimizing revenue).”58 Even if the overall combination of benefits was unanticipated by Congress, the substance-over-form doctrine does not “give the Commissioner a warrant to search through the Internal Revenue Code and correct whatever oversight Congress happens to make.”59 To whatever extent arguments in these decisions of the Courts are usable before the Tax Court, the (M)BRS, being a composition of Congressionally enacted tax avoidance steps entirely undertaken within Congressionally-created tax avoidance vehicles, and not involving any distortions of economic substance, is therefore fully legitimate.

Past recharacterizations. Existing case law upholds the ability of the IRS to recharacterize contributions to Roth IRAs in some circumstances. For example, when sham corporations are established within Roth IRAs and paid fees for nonexistent services, they may be recharacterized as direct contributions.60 Similarly, when ownership of a foreign sales corporation (FSC) is purchased within a Roth IRA, the income received from the FSC within the IRA may also be recharacterized as direct contributions.61 In Mazzei v. Commissioner, an appeal would be heard by the Ninth Circuit, so the earlier decision of Summa II was not binding and the Tax Court had the option of recapitulating the same argument. Even if Summa II were binding, the taxpayer before Sixth Circuit was Summa Holdings and “consequently the issue before that court was limited to whether the commissions paid to the DISC were deductible,” meaning that “the issue of whether the payments to the Roth IRAs were contributions” was not formally ruled upon by the Sixth Circuit.62 Nevertheless, the Court also concluded that Summa II “pertained to a related but different issue” and chose not to recapitulate the same arguments.63 Notably, the Tax Court itself “acknowledge[s] that the substance-over-form doctrine is not something the Commissioner can use to pound every Roth IRA transaction he doesn’t like,” elaborating in Block Developers et al. v. Commissioner upon the reversal of its decision in Summa I by the Sixth Circuit being based upon the “congressionally sanctioned intent” of a DISC being tax avoidance, in contrast to the present case involving LLCs, which are meant to have a “real business purpose.”64 As such, even in Circuits where the decisions of Summa II, Benenson I, and Benenson II are not binding upon the Tax Court, the limitations they describe on the substance-over-form doctrine may nevertheless be recognized to at least some extent by the Tax Court.

Overall argument. The argument for the legitimacy of the (M)BRS is as follows: Roth IRAs and conversions into them are “designed [by Congress] for tax-reduction purposes,”65 which the Commissioner must respect for the purposes of applying the substance-over-form doctrine because the doctrine is a “tool of statutory interpretation.”66 Similarly with DISCs, which are “all form and no substance,”67 it would be inappropriate to say that usage of the (M)BRS for tax avoidance is somehow unreflective of economic substance when the substance of the tax instruments and conversions which it utilizes is, as determined by statute and Congressional intent, purely tax avoidance. Consequently, it cannot be argued that execution of the (M)BRS is tantamount to “a labeling-game sham or [a defiance] of economic reality,” either of which would be a basis for recharacterization.68 This is in contrast to cases such as Mazzei and Repetto which do involve distortions of economic reality, and which the Tax Court has repeatedly recognized as distinct from the issues raised in Summa I on account of the constructions used therein (LLCs, FSCs, etc.) as statutorily possessing economic substance aside from tax avoidance.69 The only remaining basis under which the Commissioner could repudiate the (M)BRS is by claiming that the substance-over-form doctrine empowers them to recharacterize lower-tax paths as otherwise equivalent higher-tax paths to the same end regardless of the economic substance of the lower-tax path or its place in the Code. However, the Sixth Circuit rejected this claim in Summa II, writing that “this broad recharacterization power travels along a one-way street” and could only be justified by “pitch[ing] the Internal Revenue Code’s purpose at an Emperor’s level of generality—that the ‘overarching’ purpose of the Code …is to increase revenue.”70 Even if this interpretation were “endorse[d] in its full flowering form,” it would remain the case that the Commissioner cannot apply it to Summa II because “[t]he point of [DISCs and Roth IRAs] is tax avoidance,” and so the Commissioner cannot limit them on the basis that he is supposedly empowered by statute to maximize revenue when the “text-driven function of these portions of the Code [which authorize DISCs and Roth IRAs]” is to minimize revenue.71 This is also true of the (M)BRS and so the same recharacterization power is equally inapplicable to the (M)BRS.

Conclusion. Current case law in the First, Second, and Sixth Circuits, as well as in the Tax Court’s own rulings and interpretations of the Circuit Courts’ rulings, suggest that the (M)BRS is fully legitimate.

Miscellaneous

Misinterpretation of Summa

Citations to the Sixth Circuit decision in Summa Holdings v. Commissioner are frequently used as the basis of claims that the (M)BRS is legitimate because it has been explicitly ruled as such by a federal court of appeals.72 Many such assertions rely exclusively upon citations to the following text in the ruling of the Court of Appeals of the Sixth Circuit:

The Commissioner persists that Congress intended Roth IRAs to be used only by median-income and low-income taxpayers, as evidenced by the contribution and income limits. We have our doubts. When pressed, the Commissioner knew of no empirical data to support the point. At any rate, Congress’s decision in 2005 to allow owners of traditional IRAs, who can make contributions regardless of income, to roll them over into Roth IRAs no matter how many assets the accounts hold or how high the owners’ incomes, see 26 U.S.C. §408A(d)(3), undercuts this contention. Those rollovers permit high-income taxpayers to avoid the income limits on Roth IRA contributions, just as the DISC permitted Summa Holdings to avoid the contribution limits. The Commissioner cannot fault taxpayers for making the most of the tax-minimizing opportunities Congress created.73

The interpretation of this paragraph as, e.g., “confirming”74 the legitimacy of the BRS is implicitly based on a reading of “avoid the income limits on Roth IRA contributions” as referring, at least in part, to the limitation of regular (i.e., direct) contributions to Roth IRAs (currently $6,000 for 2019).75 Leaving aside the observation that this decision is not binding on the Tax Court outside of the Sixth Circuit, there exists a more natural interpretation of the quoted paragraph which does not endorse the legitimacy of the BRS. It is an interpretation wherein “contributions” is read as referring solely to qualified rollover contributions. This interpretation is more natural because the quoted text refers directly to “Congress’s decision in 2015” to permit rollovers into Roth IRAs without income limitations, specifically §512(a)(1) of the Tax Increase Prevention and Reconciliation Act of 2005—with section heading “Conversions to Roth IRAs” and subsection heading “Repeal of income limitations”—which struck out a subparagraph imposing an adjusted gross income-based limitation on a taxpayer’s ability to make a “qualified rollover contribution to a Roth IRA”.76 Such contributions are substantively different from direct contributions at least insofar as they are subject to different qualifying requirements for withdrawal without triggering a penalty tax,77 and consequently the two interpretations discussed herein cannot be understood as being synonymous. Accordingly, the proposed interpretation of “contributions” as referring specifically to qualified rollover contributions is both more natural than and clearly distinct from interpretations of “contributions” which include regular contributions, leaving opening the possibility that the quoted text is merely a narrow restatement of already-explicit Congressional intent rather than a broader endorsement of the BRS.

Congressional comments

Many popular news articles and blogs reported in 2018 that Congress had explicitly approved the BRS.78 However, this claim is entirely unwarranted.

The basis for this claim was the presence of text in footnotes of a Congressional conference committee on the Tax Cuts and Jobs Act of 2017. In a discussion of present law concerning retirement savings accounts, the report mentions that individuals “can” perform a sequence of tax maneuvers resembling the (M)BRS BRS.79 The existence of these Congressional comments should not factor into decisions regarding the legitimacy of the (M)BRS for several reasons:

  1. Congressional reports are not statutory law and are not legally binding. Additionally, Congressional reports originating prior to passage of a bill may be evidence in regard to Congressional intent, but the same does not generally hold of Congressional expressions originating after passage.80
  2. The area of the Code weakest to indirect evidence regarding Congressional intent is arguably Title 26.81 Additionally, Congressional intent is less binding than the written word of the Code.
  3. Even if it were possible to successfully litigate a case in defense of the BRS, it would likely be financially unwise.

As such, arguments reliant upon these Congressional comments should be dismissed.

Past IRS action

Past action is typically a useful predictor of future action, both in regard to whether or not the anti-(M)BRS audit policies are actively enforced by IRS agents and in regard to the possibility of retroactive enforcement action should the IRS decide that the (M)BRS are illegitimate tax maneuvers.

One credible secondhand report of IRS enforcement action against the (M)BRS exists, in which IRS agents performing an audit for non-(M)BRS reasons required reversal of BRS conversions.82 In contrast, there are a number of anecdotal reports of the (M)BRS surviving IRS scrutiny.83 There are no known reports of IRS agents actively pursuing individuals executing the (M)BRS. Similarly, no court cases exist where the IRS has taken an explicitly anti-(M)BRS position.

In a recent case when the Tax Court ruled that a previously commonly held interpretation of IRS rules was incorrect, the IRS left a 1-year grace period in between release of the ruling and enforcement of the new interpretation and did not perform any retroactive enforcement.84

Footnotes

  1. “For purposes of paragraph (1)(A) [regarding the maximum amount of deduction allowable from a traditional IRA] …the deductible amount is $5,000” (26 USC §219(b)(5)(A)), subject to annual cost-of-living adjustments (26 USC §219(b)(5)(C)). Furthermore, “the aggregate amount of contributions …to all Roth IRAs …shall not exceed the excess …of the maximum amount allowable as a deduction under section 219 …, over the aggregate amount of contributions …to all other individual retirement plans (other than Roth IRAs) [i.e., traditional IRAs]” (26 USC §408A(c)(2)). From these two clauses it necessarily follows that the limitation described in §219(b)(5)(A), after accounting for cost-of-living increases, is a limitation on the total sum of contributions to both traditional and Roth IRAs. As confirmation, IRS guidance specifies that “your contribution limit [to a Roth IRA] is …[the limitation described in §219(b)(5)(A)] minus all contributions …to all IRAs other than Roth IRAs” (IRS Publication 590-A (Feb 28, 2018), p. 41), assuming income is not extremely low.↩
  2. “[T]here shall be allowed as a deduction an amount equal to the qualified retirement contributions of the individual for the taxable year” (26 USC §219(a)), subject to the other conditions described in §219. As confirmation, IRS guidance specifies that “[g]enerally, you can deduct the lesser of: the contributions to your traditional IRA for the year, or the general limit [for contributions into traditional and Roth IRAs]” (IRS Publication 590-A (Feb 28, 2018), p. 10).↩
  3. Refer to the guidance given in IRS Publication 590-A (Feb 28, 2018), which describes no specific limitations on the proportional composition of contributions to traditional vs. Roth IRAs so long as various contribution limits are satisfied.↩
  4. Refer to descriptions of phase-outs given in 26 USC §219(g)(3)(B)(iii) and 26 USC §408A(c)(3)(B)(ii)(II).↩
  5. “The applicable dollar amount under Section 219(g)(3)(B)(i) for determining the deductible amount of an IRA contribution for …all other taxpayers who are active participants (other than married taxpayers filing separate returns) increased from $63,000 to $64,000. …The adjusted gross income limitation under Section 408A(c)(3)(B)(ii)(I) for determining the maximum Roth IRA contribution for …all other taxpayers (other than married taxpayers filing separate returns) is increased from $120,000 to $122,000” (IRS News Release: 401(k) contribution limit increases to $19,000 for 2019; IRA limit increases to $6,000 (Nov 1, 2018)).↩
  6. “The term ‘nondeductible limit’ means the excess of the amount allowable as a deduction under section 219 (determined without regard to section 219(g)), over the amount allowable as a deduction under section 219 (determined with regard to section 219(g))” (26 USC §408(o)(2)(B)(i)), suggesting that nondeductible contributions to traditional IRAs may be made insofar as deductible contributions are phased-out by §219(g). Furthermore, “[t]axpayer[s] may elect to treat deductible contributions as nondeductible” (26 USC §408(o)(2)(B)(ii)), allowing for nondeductible contributions in preference to deductible contributions. IRS guidance holds that “[t]he difference between your total permitted contributions and your IRA deduction, if any, is your nondeductible contribution” (IRS Publication 590-A (Feb 28, 2018), p. 15)—presumably few taxpayers, if any, choose to make nondeductible contributions in preference to deductible contributions.↩
  7. Originally, “[a] taxpayer shall not be allowed to make a qualified rollover contribution to a Roth IRA …if … the taxpayer’s adjusted gross income exceeds $100,000,” but this clause, among others, was struck out by by the Tax Increase Prevention and Reconciliation Act of 2005, effective taxable year 2010 (26 USC §408A; Pub. L. 109–222 §512(a)(1)). IRS guidance confirms that “[f]or Roth conversions only, there are no longer any income or filing status conditions for 2010 and beyond” (IRS Transcript for the Basics of Roth Conversions Retirement Planning Employee Plans (Sept 30, 2010)).↩
  8. “For purposes of applying section 72 [concerning taxation of distributions] to any amount described in paragraph (1) [concerning distributions from a traditional IRA] … all individual retirement plans shall be treated as 1 contract” (26 USC §408(d)(2)), whereas an “individual retirement plan” is a traditional IRA as defined by 26 USC §408(a). Consequently, the distribution is subject to pro-rata calculation of pre-tax and after-tax proportions applied to the aggregate account as per 26 USC §72(e)(8)(B).↩
  9. In general, “any amount paid or distributed out of an individual retirement plan [e.g., a traditional IRA] shall be included in gross income by the payee or distributee,” with an exception being “if …the entire amount received …is paid into an eligible retirement plan [such as a 401(k)] …except that the maximum amount which may be paid into such plan may not exceed the portion of the amount received which is includible in gross income” (26 USC §408(d)(3)(ii)). The exemption from inclusion in gross income “in the manner provided under section 72” precludes the application of the pro-rata calculation as well as the application of the aggregation rule, which is only valid “for purposes of applying section 72” to the taxation of inclusions in gross income (26 USC §408(d)(2)), such that even if a distribution is requested from a traditional IRA and after-tax balances are present in either the same or separate traditional IRAs, it is possible to designate solely the pre-tax funds to be rolled over into the 401(k) plan.↩
  10. “[T]he taxpayer’s tax …in which such amount [received from a qualified distribution plan] is received shall be increased by an amount equal to 10 percent of the portion of such income which is includible in gross income” (26 USC §72(t)(1)). However, “[a] distribution from a Roth IRA is not includible in the owner’s gross income …to the extent that it is a return of the owner’s contributions to the Roth IRA” (26 CFR §1.408A-6, A-1(b)), and consequently regular contributions (excluding earnings) may be withdrawn at any time without tax or penalty. In contrast, “[t]he 10-percent additional tax …also applies to a nonqualified distribution, even if it is not includible in gross income, to the extent it is allocable to a conversion contribution, if the distribution is made within the 5-taxable-year period beginning …in which the conversion contribution was made” (26 CFR §1.408A-6, A-5(b)). Accordingly, IRS guidance holds that “[i]f, within the 5-year period …in which you convert an amount from a traditional IRA or rollover an amount from a qualified retirement plan to a Roth IRA, you take a distribution from a Roth IRA, you may have to pay the additional 10% tax on early distributions …on any amount attributable to the part of the amount converted or rolled over …that you had to include in income” (IRS Publication 590 (Jan 5, 2014), pp. 70–71).↩
  11. “[T]he elective deferrals of any individual for any taxable year shall be included in such individual’s gross income to the extent the amount of such deferrals for the taxable year exceeds the applicable dollar amount” (26 USC §402(g)(1)), whereas the “applicable dollar amount” is defined to be $15,000 (26 USC §402(g)(2)), along with cost-of-living adjustments “in the same manner as under section 415(d)” (26 USC §402(g)(4)).↩
  12. “Contributions and other additions with respect to a participant [into defined contribution plans] exceed the limitation of this subsection if, when expressed as an annual addition …is greater than the lesser of …$40,000, or …100 percent of the participant’s compensation” (26 USC §415(c)(1)), whereas the limitation of $40,000 is subject to “increases in the cost-of-living” (26 USC §415(d)(1)(C)).↩
  13. “The limitation for defined contribution plans under Section 415(c)(1)(A) is increased in 2019 from $55,000 to $56,000. …The limitation under Section 402(g)(1) on the exclusion for elective deferrals described in Section 402(g)(3) is increased from $18,500 to $19,000” IRS News Release: 401(k) contribution limit increases to $19,000 for 2019; IRA limit increases to $6,000 (Nov 1, 2018).↩
  14. It is possible in principle that a taxpayer might strictly prefer the tax advantages of a Roth IRA over elective deferrals into a 401(k) account, in which case the taxpayer could solely make after-tax contributions into their 401(k) and convert the entire sum into a Roth IRA. The limitations on elective deferrals are mentioned here primarily because taxpayers who have incomes high enough to want to take advantage of the MBRS typically maximize tax-deductible (non-Roth) elective deferrals into their 401(k) plans on the basis of high marginal tax rates.↩
  15. “[E]mployee contributions (and any income allocable hereto) under a defined contribution plan may be treated as a separate contract” (26 USC §72(d)(2)), wherein “defined contribution plan[s]” (in Title 26) include, inter alia, “plan[s] described in section 401(a)” (26 USC §415(k)(1)(A)), including 401(k) plans, which necessarily meet the requirements of section 401(a) (26 USC §401(k)(2)). Interpreted by the IRS explicitly as: “Section 72(e)(9) (added by TRA ’86) provides that, for purposes of applying section 72(e) to nonannuity distributions, employee contributions (and earnings thereon) under a defined contribution plan are to be treated as under a contract that is separate from the remaining portion of the plan” (IRS Notice 87-13, Q&A-14, in Internal Revenue Cumulative Bulletin 1987-1, pp. 437–438). Note that 72(e)(9) was later moved to 72(d)(2) as a “technical correction” to better reflect Congressional intent (Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986 (May 4, 1987), p. 724).↩
  16. “Separate accounting shall not be treated as acceptable unless (i) the plan maintains a record for the contributions (and earnings thereon) comprising the separate 72(e)(9) contract that accounts for such contributions (and earnings thereon) separately from the other contributions (and earnings thereon) held under the plan, and (ii) the gains, losses, distributions, forfeitures, and other credits and charges are allocated between the separate 72(e)(9) contract and the other contract (or contracts) under the plan on a reasonable and consistent basis. …Thus, for example, separate accounting will not be treated as acceptable if credits and charges resulting from two classes of contributions (e.g., employee contributions and employer contributions) are not allocated between such classes on a reasonable and consistent basis” (IRS Notice 87-13, Q&A-14, in Internal Revenue Cumulative Bulletin 1987-1, p. 438). Note that 72(e)(9) is an outdated reference to 72(d)(2) (see previous footnotes).↩
  17. “In order for a contract to be recognized as a separate 72(e)(9) contract, a plan …must either specify the contract from which distributions are to be made or permit participants to designate the contract from which a requested distribution is to be made” (ibid., p. 438). Additionally, an example is provided wherein “the participant makes an employee contribution of $2,500 in each year from 1987 through 1990,” with matched employer contributions on a dollar-for-dollar basis and with separate accounting for employee and employer contributions, and “elects to receive a distribution of $2,000 from the contract comprising of employee contributions (and earnings thereon). Because this contract is treated as separate from the portion of the plan comprised of employer contributions (and earnings thereon), the rules of section 72(e) are applied to the distribution of employee contributions (and earnings thereon) by disregarding the participant’s employer contributions (and earnings thereon)” (ibid., pp. 438–439). Again, note that 72(e)(9) is an outdated reference to 72(d)(2), and that the scoping of 72(e)(9), previously limited to 72(e), was expanded in a correction to the entirety of 26 USC §72.↩
  18. “Earnings associated with after-tax contributions are pretax amounts in your account” (IRS publication Rollovers of After-Tax Contributions in Retirement Plans (Jul 30, 2018)).↩
  19. “Under a defined contribution plan, your contributions (and income allocable to those contributions) may be treated as a separate contract for figuring the taxable part of any distribution. The employer contributions (and income allocable to those contributions) wouldn’t be considered part of that separate contract,” wherein the “figuring” of the taxable part of a distribution is performed pursuant to the formula
    $$\text{tax-free amount} = \text{amount received} \times \frac{\text{cost of contract}}{\text{account balance}}$$
    (IRS Publication 575 (Mar 2, 2018), p. 17). The given Example clarifies that the numerator of the fraction, i.e. the “cost of contract,” is interpreted as the sum of employee contributions in the after-tax account in a general (not necessarily annuity) defined contribution plan when performing the above calculation for a non-annuity distribution (ibid., p. 17), which is pursuant to the Code description of “amounts not received as annuities” as being “included in gross income to the extent allocable to income on the contract …[and] not included in gross income to the extent allocable to the investment on the contract” (26 USC §72(e)(2)(B)), whereas the allocations of amounts received between amounts allocable to income on the contract and amounts allocable to the investment on the contract are proportional to the division of the account balance between those two categories (26 USC §72(e)(8)(B)). Further, the applicability of 72(e) to 401(k) plans is pursuant to 26 USC §402(a), and is confirmed by IRS guidance noting that “[i]f a participant’s account balance in a plan qualified under §401(a) …includes both after-tax and pretax amounts, then, under §72(e)(8), each distribution from the account …will include a pro rata share of both after-tax and pretax amounts” (IRS Notice 2014-54, p. 1).↩
  20. “[A]mounts held by the trust which are attributable to employer contributions made pursuant to the employee’s election …may not be distributable to participants or other beneficiaries earlier than … [inter alia,] the attainment of age 59.5” (26 USC §401(k)(B)(i)(III)).↩
  21. It is impossible to prove a negative, but evidence of age-based restrictions on distributions of employee contributions has not yet been found despite a careful search.↩
  22. A “qualified rollover contribution” to a Roth IRA was originally restricted to rollovers originating from “individual retirement plans,” but was subsequently amended by the Pension Protection Act of 2006 to allow those originating from “eligible retirement plans …as defined in section 402(c)(8)(B),” which includes “qualified trusts,” i.e. those retirement plans satisfying the 401(a) regulations, necessarily including 401(k) plans (Pub. L. 109–280 §824; 26 USC §408A(e); 26 USC §402(c)(8)(B); 26 USC §401(a) and 401(k)). Explicit IRS guidance asserts that distributions from a “qualified plan described in §401(a)” can be rolled over to a Roth IRA such that “there is included in gross income any amount that would be includible if the distribution were not rolled over” (IRS Notice 2008-30, pp. 1–2).↩
  23. “[A]ll disbursements of benefits from the plan to the recipient that are scheduled to be made at the same time …are treated as a single distribution without regard to whether the recipient has directed that the disbursements be made to a single destination or multiple destinations. …[I]f the direct rollover is to two or more plans, then the recipient can select how the pretax amount is allocated among these plans. …If, after the assignment of the pretax amount to …rollovers …there is a remaining pretax amount, that amount is includible in the distributee’s gross income” (IRS Notice 2014-54, pp. 3–4). Since the rollover to multiple plans is treated as a single distribution, when the targets of the rollover consist of a traditional IRA and a Roth IRA, allocating the entirety of the pre-tax funds to the traditional IRA means that the after-tax funds are necessarily allocated to the Roth IRA. This interpretation is explicitly supported by Example 4 wherein when “Employee C chooses to make a direct rollover of $80,000 to a traditional IRA and $20,000 to a Roth IRA[,] Employee C is permitted to allocate the $80,000 that consists entirely of pretax amounts to the traditional IRA so that the $20,000 rolled over to the Roth IRA consists entirely of after-tax amounts” (ibid., p. 5)↩
  24. “The term highly compensated employee means any employee who— (A) was a 5-percent owner at any time during the year or the preceding year, or (B) for the preceding year— (i) had compensation from the employer in excess of $80,000, and (ii) if the employer elects the application of this clause for such preceding year, was in the top-paid group of employees for such preceding year” (26 USC §414(q)(1)). Several clarifications apply. A 5-percent owner is, “if the employer is a corporation, any person who owns …more than 5 percent of the outstanding stock of the corporation or stock possessing more than 5 percent of the total combined voting power of all stock of the corporation, [whereas] if the employer is not a corporation, any person who owns more than 5 percent of the capital or profits interest in the employer” (26 USC §416(i)(1), referenced by 26 USC §414(q)(2)). “An employee is in the top-paid group of employees for any year if such employee is in the group consisting of the top 20 percent of the employees when ranked on the basis of compensation paid during such year” (26 USC §414(q)(3)). Finally, the limitation of $80,000 is adjusted “at the same time and in the same manner as under section 415(d)” (26 USC §414(q)(1)(B)(ii)).↩
  25. “The term ‘key employee’ means an employee who, at any time during the plan year, is— (i) an officer of the employer having an annual compensation greater than $130,000, (ii) a 5-percent owner of the employer, or (iii) a 1-percent owner of the employer having an annual compensation from the employer of more than $150,000. …[T]he $130,000 amount in clause (i) shall be adjusted at the same time and in the same manner as under section 415(d)” (26 USC §416(i)(1)). 5-percent owner is defined as supra (26 USC §416(i)(B)(i)), and 1-percent owner is defined with reference to the definition of 5-percent owner (26 USC §416(i)(B)(ii)).↩
  26. “A plan meets the contribution percentage requirement of this paragraph for any plan year only if the contribution percentage for eligible highly compensated employees for such plan year does not exceed the greater of— (i) 125 percent of such percentage for all other eligible employees for the preceding plan year, or (ii) the lesser of 200 percent of such percentage for all other eligible employees for the preceding plan year, or such percentage for all other eligible employees for the preceding plan year plus 2 percentage points. This subparagraph may be applied by using the plan year rather than the preceding plan year if the employer so elects” (26 USC §401(m)(2)). Additionally, “the contribution percentage for a specified group of employees for a plan year shall be the average of the ratios …of— (A) the sum of the matching contributions and employee contributions paid under the plan on behalf of each such employee for such plan year, to (B) the employee’s compensation …for such plan year” (26 USC §401(m)(3)).↩
  27. “A cash or deferred arrangement shall not be treated as [such] unless (i) those employees eligible to benefit …satisfy the provisions of section 410(b)(1), and (ii) the actual deferral percentage for eligible highly compensated employees …for the plan year bears a relationship to the actual deferral percentage for all other eligible employees for the preceding plan year which meets either of the following tests: (I) The actual deferral percentage for the group of eligible highly compensated employees is not more than the actual deferral percentage of all other eligible employees multiplied by 1.25. (II) The excess of the actual deferral percentage for the group of eligible highly compensated employees over that of all other eligible employees is not more than 2 percentage points, and the actual deferral percentage for the group of eligible highly compensated employees is not more than the actual deferral percentage of all other eligible employees multiplied by 2. …An arrangement may apply clause (ii) by using the plan year rather than the preceding plan year if the employer so elects” (26 USC §401(k)(3)(A)).↩
  28. “The term ‘top-heavy plan’ means, with respect to any plan year … any defined contribution plan if, as of the determination date, the aggregate of the accounts of key employees under the plan exceeds 60 percent of the aggregate of the accounts of all employees under such plan” (26 USC §416(g)(1)(A)). “The term ‘determination date’ means, with respect to any plan year— (i) the last day of the preceding plan year, or (ii) in the case of the first plan year of any plan, the last day of such plan year” (26 USC §416(g)(4)(C)).↩
  29. “For purposes of determining— (i) the present value of the cumulative accrued benefit for any employee, or (ii) the amount of the account of any employee, such present value or amount shall be increased by the aggregate distributions made with respect to such employee under the plan during the 1-year period ending on the determination date” (26 USC §416(g)(3)(A)). Additionally, “[i]n the case of any distribution made for a reason other than severance from employment, death, or disability, subparagraph (A) shall be applied by substituting ‘5-year period’ for ‘1-year period’ ” (26 USC §416(g)(3)(B)). Moreover, “any rollover contribution …initiated by the employee …to a plan shall not be taken into account with respect to the transferee plan for purposes of determining whether such plan is a top-heavy plan” (26 USC §416(g)(4)(A)).↩
  30. For the ACP test, “[a] plan is permitted to change from the prior year testing method to the current year testing method for any plan year” (26 CFR §1.401(m)-2(c)(1)). Similarly, for the ADP test, “[a] plan is permitted to change from the prior year testing method to the current year testing method for any plan year” (26 CFR §1.401(k)-2(c)(1)(i)).↩
  31. For the ACP test, “[a] plan is permitted to change from the current year testing method to the prior year testing method only in situations described in §1.401(k)-2(c)(1)(ii)” (26 CFR §1.401(m)-2(c)(1)), referencing the condition for the ADP test, pursuant to which “[a] plan is permitted to change from the current year testing method to the prior year testing method only in situations described in paragraph (c)(1)(ii) of this section,” (26 CFR §1.401(k)-2(c)(1)(i)), one of which is that “the current year testing method was used under the plan for each of the 5 plan years preceding the plan year of the change (or if lesser, the number of plan years the plan has been in existence, including years in which the plan was a portion of another plan)” (26 CFR §1.401(k)-2(c)(1)(ii)(A)).↩
  32. “[A] plan that uses the safe harbor method …is treated as using the current year testing method for that plan year” (26 CFR §1.401(m)-2(c)(1) and 26 CFR §1.401(k)-2(c)(1)(i)).↩
  33. “[A] plan may use the current year testing method or prior year testing method for the ACP test for a plan year without regard to whether the current year testing method or prior year testing method is used for the ADP test for that year” (26 CFR §1.401(m)-2(c)(3)), and similarly, “a plan may use the current year testing method or prior year testing method for the ADP test for a plan year without regard to whether the current year testing method or prior year testing method is used for the ACP test for that year” (26 CFR §1.401(k)-2(c)(3)). In both cases, various other conditions also apply.↩
  34. For the ACP test, “[q]ualified nonelective contributions cannot be taken into account …to the extent such contributions are taken into account for purposes of satisfying any other ACP test, any ADP test, or the requirements of §1.401(k)-3, 1.401(m)-3 or 1.401(k)-4” (26 CFR §1.401(m)-2(a)(6)(vi)). Similarly, for the ADP test, “[q]ualified nonelective contributions and qualified matching contributions cannot be taken into account under this paragraph (a)(6) to the extent such contributions are taken into account for purposes of satisfying any other ADP test, any ACP test, or the requirements of §1.401(k)-3, 1.401(m)-3 or 1.401(k)-4” (26 CFR §1.401(k)-2(a)(6)(vi)).↩
  35. “A plan shall not be treated as failing to meet the requirements of paragraph (1) for any plan year if, before the close of the following plan year, the amount of the excess aggregate contributions for such plan year (and any income allocable to such contributions through the end of such year) is distributed” (26 USC §401(m)(6)(A)). Refer additionally to IRS guidance at 401(k) Plan Fix-It Guide – The plan failed the 401(k) ADP and ACP nondiscrimination tests. (Nov 7, 2018).↩
  36. For the ACP test, “qualified nonelective contributions and elective contributions may be taken into account in determining the ACR for an eligible employee for a plan year or applicable year” (26 CFR §1.401(m)-2(a)(6)). Similarly for the ADP test, “qualified nonelective contributions and qualified matching contributions may be taken into account in determining the ADR for an eligible employee for a plan year or applicable year” (26 CFR §1.401(k)-2(a)(6)). In both cases various conditions apply.↩
  37. “A trust shall not constitute a qualified trust under section 401(a) for any plan year if the plan of which it is a part is a top-heavy plan for such plan year unless such plan meets— (1) the vesting requirements of subsection (b), and (2) the minimum benefit requirements of subsection (c)” (26 USC §416(a)), whereas part of the minimum benefit requirements specify that “the employer contribution [into a defined contribution plan] for the year for each participant who is a non-key employee is not less than 3 percent of such participant’s compensation …. Employer matching contributions …shall be taken into account for purposes of this subparagraph” (26 USC §416(c)(2)(A)). Additionally, “[the percentage referred to in subparagraph (A) for any year shall not exceed the percentage at which contributions are made (or required to be made) under the plan for the year for the key employee for whom such percentage is the highest for the year” (26 USC §416(c)(2)(B)(i)). See also IRS guidance in 401(k) Plan Fix-It Guide – The plan was top-heavy and required minimum contributions weren’t made to the plan. (Nov 7, 2018). Additional vesting requirements on all employee contributions also apply (26 USC §416(b)).↩
  38. “A cash or deferred arrangement shall be treated as meeting the requirements of paragraph (3)(A)(ii) if such arrangement— (i) meets the contribution requirements of subparagraph (B) or (C), and (ii) meets the notice requirements of subparagraph (D)” (26 USC §401(k)(12)(A)), whereas the requirement in (i) is met if “the employer makes matching contributions on behalf of each employee who is not a highly compensated employee in an amount equal to— (I) 100 percent of the elective contributions of the employee to the extent such elective contributions do not exceed 3 percent of the employee’s compensation, and (II) 50 percent of the elective contributions of the employee to the extent that such elective contributions exceed 3 percent but do not exceed 5 percent of the employee’s compensation,” along other with various rules on matching contributions (26 USC §401(k)(12)(B)), or if “the employer is required, without regard to whether the employee makes an elective contribution or employee contribution, to make a contribution to a defined contribution plan on behalf of each employee who is not a highly compensated employee … in an amount equal to at least 3 percent of the employee’s compensation” (26 USC §401(k)(12)(C)).↩
  39. “A defined contribution plan shall be treated as meeting the requirements of paragraph (2) with respect to matching contributions if the plan— (i) meets the contribution requirements of subparagraph (B) or (C) of subsection (k)(12), (ii) meets the notice requirements of subsection (k)(12)(D), and (iii) meets the requirements of subparagraph (B)” (26 USC §401(m)(11)(A)), whereas the reference of (iii) stipulates that “[t]he requirements of this subparagraph are met if— (i) matching contributions on behalf of any employee may not be made with respect to an employee’s contributions or elective deferrals in excess of 6 percent of the employee’s compensation [and various other conditions]” (26 USC §401(m)(11)(B)).↩
  40. “If the plan provides for employee contributions, in addition to satisfying the requirements of this section, it must also satisfy the ACP test of §1.401(m)-2. See §1.401(m)-2(a)(5)(iv) for special rules under which the ACP test is permitted to be performed disregarding some or all matching when this section is satisfied with respect to the matching contributions” (26 CFR §1.401(m)-3(j)(6)).↩
  41. “A plan that satisfies the ACP safe harbor requirements of section 401(m)(11) or 401(m)(12) for a plan year but nonetheless must satisfy the requirements of this section because it provides for employee contributions for such plan year is permitted to apply this section disregarding all matching contributions with respect to all eligible employees” (26 CFR §1.401(m)-2(a)(5)(iv)).↩
  42. “The term ‘top-heavy plan’ shall not include a plan which consists solely of— (i) a cash or deferred arrangement which meets the requirements of section 401(k)(12) or 401(k)(13), and (ii) matching contributions with respect to which the requirements of section 401(m)(11) or 401(m)(12) are met” (26 USC §416(g)(4)(H)).↩
  43. Summa Holdings, Inc., et al. v. Commissioner of Internal Revenue, T.C. Memo. 2015-119 (2015).↩
  44. The purpose of a DISC is to serve as a flow-through which allows the shareholders of an exporter company to “defer Federal income tax on income from exports …until the earnings are actually distributed” as dividends to its shareholders (ibid., p. 13). It is understood as↩
  45. The holding corporation “was organized, in part, so that the Benenson Roth IRAs would not have unrelated business income …and, in part, so that the custodians of the Benenson Roth IRAs would no longer be involved as shareholders of JC Export” (ibid., p. 5).↩
  46. For example, disregarding the formal creation of a corporation which “[is] nothing more than a contrivance to [a specific] end …brought into existence for no other purpose … [and] immediately was put to death [following consummation of its tax-reduction passthrough role]” (Gregory v. Helvering, 293 U.S. 465 (1935), pp. 469–470). In application of the doctrine, the Supreme Court “has looked to the objective economic realities of a transaction rather than to the particular form the parties employed” (Frank Lyon Co. v. United States, 435 U.S. 561 (1978), p. 573), and in particular at whether or not the formal transaction “lies outside the plain intent of the statute” by which the formal transaction is claimed to justify a lower-tax treatment as compared to the recharacterized transaction (Gregory v. Helvering, 293 U.S. 465 (1935), pp. 470)↩
  47. Summa Holdings et al. v. Commissioner, T.C. Memo. 2015-119 (2015), p. 11.↩
  48. Ibid., pp. 17–18.↩
  49. Summa Holdings, Inc. v. Commissioner of Internal Revenue, No. 16-1712 (6th Cir. 2017), p. 14.↩
  50. “Perhaps the greatest caveat to the backdoor Roth contribution strategy, though, is the so-called ‘’step transaction doctrine’, which allows the Tax Court to recognize that even if the individual contribution-and-conversion steps are legal, doing them all together in an integrated transaction is still an impermissible Roth contribution for high-income individuals to which the 6% excess contribution penalty tax may apply” (Michael Kitces, How To Do A Backdoor Roth IRA (Safely) And Avoid The IRA Aggregation Rule And Step Transaction Doctrine (Aug 12, 2015)).↩
  51. “The step transaction doctrine is in effect another rule of substance over form” (Penrod v. Commissioner, 88 T.C. 1415, pp. 1428–1429 (1987)). Additionally, in reference to “the search for the substance of transactions as opposed to their forms[,] …[t]he step transaction doctrine is the name that has been given to one method courts have used in fitting events into the descriptions provided by the statute for taxable transactions” (Richard D. Hobbet, The Step Transaction Doctrine and Its Effect on Corporate Transactions, 19 Proceedings of the Annual Tulane Tax Institute 102–142 (1970), p. 102).↩
  52. Summa Holdings, Inc. v. Commissioner, No. 16-1712 (6th Cir. 2017).↩
  53. Clement C. Benenson v. Commissioner of Internal Revenue, No. 16-2066 (1st Cir. 2018).↩
  54. James Benenson, Jr. and Sharen Benensen v. Commissioner of Internal Revenue, No. 16-2953 (2d Cir. 2018).↩
  55. Benenson v. Commissioner, No. 16-2066 (1st Cir. 2018), p. 26.↩
  56. “When two potential options for structuring a transaction lead to the same end and the taxpayers choose the lower-tax path, the Commissioner claims the power to recharacterize the transactions as the higher-taxed equivalents. It’s not that the transactions don’t have economic substance …or that the Code forbids them …. Instead, the Commissioner simply stipulates that the ‘real’ transaction is the higher-taxed one, and that the lower-taxed route, often the more complex of the two, is a mere ‘formality’ he can freely disregard. The Commissioner claims the right to assert this power against ‘any given transaction[,] based on [the] facts and circumstances’ of the arrangement” (Summa Holdings, Inc. v. Commissioner, No. 16-1712 (6th Cir. 2017), p. 9).↩
  57. Ibid., p. 12↩
  58. Ibid., p. 13.↩
  59. Ibid., p. 14.↩
  60. “The invoices in the record strongly support our conclusion that the services agreements and payments were mechanisms to transfer value to the Roth IRAs” (Repetto v. Commissioner, T.C. Memo. 2012-168 (2012)).↩
  61. “Petitioners suggest that when their Roth IRAs formally purchased the FSC, the Roth IRAs thereby acquired the right (represented by the FSC stock) to receive income from the FSC. But a formal purchase does not necessarily mean that for tax purposes the Roth IRAs should be treated as the recipients of income from the FSC; the question is who had power and control over the FSC or over receipt of the dividend income” (Celia Mazzei et al. v. Commissioner of Internal Revenue, 150 T.C. No. 7, p. 40).↩
  62. Ibid., pp. 52–53.↩
  63. Ibid., p. 51.↩
  64. Block Developers, LLC, et al., v. Commissioner of Internal Revenue, T.C. Memo. 2017-142 (2017), pp. 30–31.↩
  65. Summa Holdings, Inc. v. Commissioner, No. 16-1712 (6th Cir. 2017), p. 8.↩
  66. Benenson v. Commissioner, No. 16-2066 (1st Cir. 2018), p. 26.↩
  67. Summa Holdings, Inc. v. Commissioner, No. 16-1712 (6th Cir. 2017), p. 8.↩
  68. Ibid., p. 9. In fact, a case questioning the economic substance of the (M)BRS would be even more favorable to the taxpayer than in Summa I, because whereas the Commissioner could have “challenged the valuation of the shares the Roth IRAs purchased in …JC Export” (but did not do so perhaps because of the statute of limitations) Benenson v. Commissioner, No. 16-2066 (1st Cir. 2018), p. 26. See also IRS guidance describing “abusive Roth IRA transactions” as those in which “[t]he acquisition of shares, the transactions or both are not fairly valued and thus have the effect of shifting value into the Roth IRA” (IRS Notice 2004-8).↩
  69. Celia Mazzei et al. v. Commissioner of Internal Revenue, 150 T.C. No. 7; Repetto v. Commissioner, T.C. Memo. 2012-168 (2012).↩
  70. Summa Holdings, Inc. v. Commissioner, No. 16-1712 (6th Cir. 2017), p. 12.↩
  71. Ibid., p. 13.↩
  72. “The U.S. Sixth Circuit Court of Appeals issued a ruling: Summa Holdings, Inc. v. Commissioner. In this related case regarding the use of two independent actions to exceed the Roth income contribution limit was both legal and proper” (Bogleheads.org, Backdoor Roth / step-transaction doctrine news: [Congress recognizes process] (retrieved Oct 9, 2018)).↩
  73. Summa Holdings, Inc. v. Commissioner, No. 16-1712 (6th Cir. 2017), p. 14)↩
  74. “Nevertheless, the Sixth Circuit in Summa Holdings v. Commissioner recently confirmed the principles of the backdoor Roth IRA strategy in its 2017 decision” (CBIZ, Show Roth the Back Door (Jul 16, 2018)).↩
  75. 26 USC §408A(c)(3)(A).↩
  76. Pub. L. 109–222 §512(a)(1); 26 USC §408(A), Notes.↩
  77. Refer to previous section on the disadvantages of BRS contributions as compared to regular Roth IRA contributions.↩
  78. Forbes, Congress Blesses Roth IRAs For Everyone, Even The Well Paid (Jan 22, 2018); Financial Advisor, IRS Finally Says Back-Door Roths Are OK (July 11, 2018); Wall Street Physician, It’s Official: Backdoor Roth IRAs Are Legal! (Jan 24, 2018); MyMoneyBlog, Backdoor Roth IRA: Now Officially Supported by Congressional Intent? (Jan 28, 2018)↩
  79. “Although an individual with AGI exceeding certain limits is not permitted to make a contribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA, as discussed below” (Joint Explanatory Statement of the Committee of Conference on H.R. 1, the Tax Cuts and Jobs Act of 2017, footnote 268). Similar comments are made in footnotes 269 and 276–277.↩
  80. “[T]he views of a subsequent Congress form a hazardous basis for inferring the intent of an earlier one” (United States v. Price, 361 U.S. 304, 313 (1960)).↩
  81. “Yes, finite language must account for infinite tax transactions. And yes, we appreciate the challenges Congress faces in this area—an endless supply of tax-reducing ingenuity. …But if there is one title of the United States Code most deserving of attention to text, it is Title 26. These are not the sparing terms of the Sherman Antitrust Act. This is the highly reticulated Internal Revenue Code, which uses language, lots of language, with nearly mathematic precision. Is there any other title of the United States Code that has devoted more carefully drawn words to reducing its purpose to text?” (Summa Holdings v. Commissioner, No. 16-1712 (6th Cir. 2017), pp. 12–13)↩
  82. “We’ve heard from a couple of people now who just on random audit had an IRS agent come in, saw it, caught it, said, that’s not appropriate, and the people actually had unwound it in part because it was easier to unwind it than to fight the IRS, which is expensive compared to a $5,500 IRA contribution” (Michael Kitces, Morningstar, ‘Backdoor’ Roth IRA May Be Closing for Investors).↩
  83. Bogleheads.org, Yet another CP2000 for Roth IRA conversion thread (retrieved Oct 9, 2018)↩
  84. “This announcement is intended to address certain concerns that have arisen since the release of Announcement 2014-15. The IRS will apply the Bobrow interpretation of §408(d)(3)(B) for distributions that occur on or after January 1, 2015” (IRS Announcement 2014-32, p. 1), referencing the ruling Alvan L. Bobrow and Elisa S. Bobrow v. Commissioner of Internal Revenue, T.C. Memo. 2014-21.↩

October 13th, 2022 | Posted in Finance

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