Backdoor Roth

WHEN YOU CONVERT a traditional IRA to a Roth IRA, you don’t have to pay taxes on your nondeductible contributions. Let’s say that, over the years, you have made $20,000 in nondeductible contributions to an IRA that are now worth $30,000. When you convert, you don’t have to pay taxes on the $20,000 in nondeductible contributions. Thus, the conversion would potentially add just $10,000 to your taxable income, while giving you a $30,000 Roth that will grow tax-free thereafter.

The funding of a nondeductible IRA, and then converting it to a Roth, is known as a “backdoor Roth”—a strategy that’s popular with high income earners who otherwise wouldn’t qualify to fund a Roth IRA. Indeed, some high income earners do this every year, first funding a nondeductible IRA and then soon after converting it to a Roth.

Sound appealing? There’s a potential hitch. Consider the example above. Suppose that, in addition to your $30,000 nondeductible IRA, you also have a $170,000 rollover IRA from your old employer’s 401(k). When you convert your $30,000, you have to assume that the money comes pro-rated from all your IRAs combined. That means it’s coming out of the $200,000 total IRA. Result: Instead of just $10,000—or 33% of the sum converted—being taxable, you would find that $27,000, or 90%, would be taxed. The reason: The $20,000 in nondeductible contributions represents just 10% of your IRA’s $200,000 total value.

What to do? If you have made nondeductible contributions and you’re considering a Roth conversion, you might hold off rolling your former employer’s 401(k) into an IRA. Alternatively, if you have that money already sitting in a rollover IRA, you may be able to move it into your new employer’s retirement plan. That might leave you with just a single IRA, containing nondeductible contributions. You could then convert that account and pay a relatively modest tax bill.

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