Monday, June 24, 2013

A Word of Caution About the “Backdoor” Roth IRA Strategy

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.
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