I thought I was done with Backdoor Roth’s, but I got a really smart question from a reader that needs
addressing.
Hidden in his question is a Backdoor Roth landmine.
Every year he makes a non-deductible contribution into his Traditional IRA, then converts it into a Roth.
That could be a really, really smart move, unless…
How it works
The money you put in a Roth has already been taxed.
So in a perfect world. you could put ALL of your taxable savings into a Roth and never pay capital gains
tax.
But the Roth contribution income limits prevent you from doing this.
Traditional IRA’s also have an income limit, but it only determines if your contribution is tax-deductible or
not.
Anyone can make a NON-DEDUCTIBLE Traditional IRA contribution. It doesn’t matter how much you
make.
So what this reader is saying is…
“Okay, so I can’t put after-tax money directly into a Roth because I make too much money. But I CAN put
it into a Traditional IRA and then convert it into a Roth.”
Pretty smart right?
THE GOTCHA
That is very smart as long as he doesn’t have a Rollover IRA.
When you roll over your old 401k, you transfer it from your 401k into a Traditional IRA.
To be descriptive, people call it a “Rollover IRA”, but it’s still just a Traditional IRA filled with money from
your old 401k that’s never been taxed.
As I’ve mentioned this week, you don’t want to convert any of your Rollover IRA into a Roth.
WARNING: LANDMINES AHEAD!
When you do a Backdoor Roth, Uncle Sam doesn’t let you choose which money from which IRA you get
to convert to a Roth.
You can’t say, “No, Uncle Sam I’m ONLY converting that after-tax money I just put in my Traditional IRA.
I’m NOT putting any of that untaxed 401k money in there.
He doesn’t it look at it that way. Uncle Sam looks at it “PRO RATA”.
That means he lumps all of your Traditional IRA in the same pot, even if their in different accounts.
That includes both the money you’ve paid taxes on and the Rollover money you have NOT.
Then he determines how much of your Backdoor Roth is taxable.
So if you have $95,000 in a Rollover IRA and then add an after-tax $5500 IRA contribution, you can’t say
I’m only converting the after-tax $5500.
Uncle Sam will say 95% of all of your Traditional IRA money has never been taxed.
Therefore 95% of your $5500 Roth conversion will be taxed.
So instead of getting around the system to put money in a Roth, you’re just paying taxes on your
Rollover IRA which is no bueno.
So an annual Backdoor Roth is a great idea if you don’t have any money in an Rollover IRA.
That might have been like drinking from the firehose, so look out next week for the video tutorial!
And if you feel like digging deeper just Google “Pro Rata Rule Backdoor Roth”
