A Word
of Caution About the “Backdoor” Roth IRA Strategy
By all accounts the “Backdoor” Roth IRA strategy that I laid out in my previous column is a terrific means through which an
otherwise ineligible individual may fund a Roth IRA – legally.
But if you already have any
other traditional IRAs with pretax contributions, there is a very important caveat
to be mindful of.
That is, under IRS rules, all traditional IRA money
must be distributed on a pro rata basis. I know we’re getting a bit technical here,
but just hang on a moment as I explain how this works using Kimberly’s scenario
as an example.
Although Kimberly’s income makes her ineligible to
contribute directly to a Roth IRA, she has just discovered that she can still
do so, using the “backdoor” strategy. So she makes a $6,500 nondeductible traditional IRA contribution
(since she’s over age 50) which she intends to immediately convert to a Roth
IRA. However, Kimberly has an existing traditional IRA worth $50,000 from
rolling over an old 401(k) – and this completely
changes things because of the pro rata rule:
As it stands now, her total traditional IRA assets ($56,500)
are made up of $6,500 nondeductible funds plus $50,000 deductible funds. As a
result Kimberly’s nondeductible ratio of every dollar that comes out of her total IRA assets is 11.5 percent ($6,500/$56,500).
What exactly does this mean for Kimberly?
If she tries to immediately convert the $6,500 to a
Roth IRA, thinking that all her contributions are nondeductible (and therefore
will be tax-free), she’d be mistaken. The IRS will consider only 11.5 percent
of the $6,500 (which amounts to $747.50) as tax-free, meaning the other 88.5
percent (or $5,752.50) will be fully taxable. Remember, the IRS considers ALL traditional IRA money (whether deductible or nondeductible) as a
single pot of money.
Nevertheless, Kimberly could get around this rule if
her current employer’s retirement plan would allow her to transfer her $50,000
deductible IRA to her 401(k). That would leave her with $6,500 IRA money, 100
percent of which is nondeductible, and therefore everything would qualify for a
tax-free Roth conversion.
Just another reason why it is usually a good idea to
talk with an experienced financial adviser before actually making any moves –
however popular and seemingly straightforward or easy they might sound.
It’s your financial future, no one else’s. Be sure to get the professional advice that will help you protect YOUR money from unforeseen challenges. Call us today at 877.656.9111 or visit us on the Web to schedule your no-strings-attached consultation!