How a Backdoor Roth IRA Can Cost You Money
Thinking About a Backdoor Roth? Don’t forget about the Pro Rata Rule, it could cost you extra tax dollars.
We’ve helped clients avoid this mistake and worked with folks who've already made it to try and clean things up.
The backdoor Roth is a popular strategy that allows people that earn too much to contribute to a Roth IRA to fund a Roth account indirectly through the ‘backdoor’ via a conversion.
It typically works like this:
There are no income limitations on Roth conversions from a Traditional IRA which is the provision that allows this strategy to work.
It can be a clean and tax-free conversion process if you don’t have any other IRA money. But most of us have money in an IRA Rollover, SEP IRA or other account that was established at some point along the way.
In the case of other IRA money, the Pro Rata Rule is something you’ll want to be aware of before executing a backdoor conversion strategy.
The IRS looks at ALL your IRA money in this scenario – pre-tax and after-tax – and they do not offer the option to choose which dollars are being converted from Traditional to Roth. A pro rata percentage is applied to determine how much of your conversion will be after-tax coming from your planned non-deductible IRA contribution.
For example, let’s say you want to make a $7,000 after-tax contribution (non-deductible) to convert to Roth via the backdoor but also have $273,000 in a IRA rollover account. The pro-rata rule would kick in and apply like this.
or in this example
$7,000 / $280,000 = 2.5%
This 2.5% is the amount of your Roth conversion that will NOT be taxable, the remaining 97.5% taxable and added to your income for the tax year.
2.5% x $7,000 = $175 tax-free conversion – adding $6,825 to your taxable income.
For someone in the 32% tax bracket you just added an extra $2,184 in tax to your bill.
You also need to track a non-deductible basis in your Traditional IRA moving forward.
Tax diversification is important and the planning around it can get complicated.
Questions? I'm here to help.
-Justin
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Seek professional tax advice.
