A Roth IRA conversion and Roth IRAs in general can be powerful tools in a retirement saver’s toolkit. The potential to accumulate a bucket of funds that can be used tax free in retirement is very attractive. This is especially true when you realize how much of your 401(k) or Traditional IRAs will be taxed in the future.
The problem, and some might argue a good problem to have, is that some savers find they are phased out because their income is over the limit and are not eligible to contribute to a Roth IRA.
While there are income limits placed on Roth IRA contributions, there are no income limits to contribute to a non-deductible IRA. A non-deductible IRA is simply a regular IRA contribution without a deduction from income also known as “after tax.”
Roth IRA Conversion – The Pro Rata Rule is Lurking
This is where a Roth IRA conversion comes in. Converting “after tax” monies from a non-deductible IRA to a Roth IRA should result in a reduced tax bill when compared to converting a Tradtional IRA (pre-tax funds). This strategy has been dubbed the “back door Roth IRA” because it can be a way for a high income earner to get money into a Roth IRA when they would otherwise be ineligible.
In this scenario, one would contribute funds to a non-deductible IRA and then convert those funds to a Roth IRA. There is no income limitation on converting to a Roth IRA but, the Pro Rata Rule can catch many by surprise.
The Pro Rata Rule prevents people from only converting non-deductible IRAs (after tax) to Roth IRAs and thus avoiding the taxes that would normally be involved in the conversion process. This rule requires you to consider ALL of your IRAs as the same account. If you have a Traditional IRA, an IRA Rollover, SIMPLE IRA or SEP IRA, those balances are considered when it comes to determining your tax owed on the conversion.
Here’s an example: After planning to make a $5,000 Roth IRA contribution, you discover that your modified adjusted gross income is beyond the limit and you are not eligible. You then decide to try a “back door Roth IRA” and make a $5,000 non-deductible IRA contribution (after tax) with the intent to convert it to a Roth IRA and avoid the tax on the conversion. The problem is that you already have a $50,000 IRA from an old 401(k) from a previous employer and the Pro Rata Rule requires you to include that as part of the calculation for taxes owed on the conversion.
Therefore, you must add up all of your non-Roth IRA funds ($50,000 IRA Rollover) and add up all of your non-deductible IRAs ($5,000 ) and determine the percentage of after tax dollars. In this scenario ($5,000/$50,000 = 10%). This is the percent that would be tax free on the conversion. A better way to look at it is that 90% would be TAXABLE. Your attempt to convert $5,000 of a non-deductible IRA (after tax IRA contribution) just resulted in 90% of that transaction being taxable.
If you’ve found yourself phased out of contributing to a Roth IRA and are considering a Roth IRA conversion, proceed with caution. the Pro Rata Rule is lurking.
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