Roth IRAs can be a powerful tool in your retirement plan. But if you earn too much you can’t contribute directly to them. That’s why high earners turn to Roth conversions to bypass these strict income limits on Roth contributions, especially because there is no limit to how much you can convert to a Roth IRA.
The strategy is simple: contribute post-tax money into a nondeductible Traditional IRA. Then convert the amount to a Roth IRA. This conversion is often called a Backdoor Roth contribution. What many retirement savers are unaware of is that this simple strategy could land them with a surprise tax bill if they don’t understand how the Pro-Rate Rule works.
Here’s an example:
Adam, whose income disqualifies him from making a direct contribution to a Roth IRA, contributes $7,000 to his nondeductible Traditional IRA. He’s contributing post-tax money, so he’s already paid taxes on his contributions. He then takes advantage of this loophole by immediately converting the full amount in his nondeductible Traditional IRA to a Roth IRA. At tax time, Adam is surprised when he discovers that his Backdoor Roth Contribution landed him with a tax bill.
So, what went wrong?
Adam has a pre-tax balance of $100,000 in an IRA Rollover and wasn’t aware of the Pro-Rate rule. The IRS uses this rule to determine how tax-deferred money should be taxed when withdrawn (or converted). This rule requires you to treat all your IRA assets as a single pool when determining taxes owed on a conversion. Essentially, if you have both pre-tax and after-tax contributions in your IRAs, like Adam had albeit briefly, the pro rata rule mandates that any conversion must include a proportional amount of both.
Here’s how to calculate the taxable portion of Adam’s Roth conversion:
$7,000 (non-deductible contribution)/$107,000 (total of all non-Roth IRA balances) = 6.54% (non-taxable percentage)
$7,000 (amount to convert to Roth) x 6.54% (non-taxable percentage) = $457.94 (amount of after-tax funds converted to Roth IRA)
This means that approximately $6,542.06 of the $7,000 you convert to the Roth IRA will be taxable, and you’ll owe income taxes on that portion.
Depending on your circumstances, there may be strategies to either avoid the pro rata rule or effectively navigate the complexities of IRA conversions so be sure to reach out to your advisor when doing a Backdoor Roth contribution.
