Backdoor Roth IRAs Could Cost Some Investors at Tax Time

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Backdoor Roth IRAs Could Cost Some

Investors at Tax Time

This maneuver could spell trouble for those with other IRA assets.

By Christine Benz | 01-03-11 | 06:00 AM | Email Article

You may have seen several mentions of the so-called backdoor IRA during the past

year and a half. Despite its illicit-sounding name, this maneuver is perfectly legal

and it can help you diversify your retirement portfolio's tax treatment.

However, if you have other IRA

assets that haven't been taxed

yet, you need to think twice

before engineering a backdoor

Roth. If you don't, your new

Roth IRA could cost you a lot

more in taxes than you had

planned.

The Maneuver

Before getting into how a

backdoor Roth can be costly from a tax standpoint, let's first discuss how this

move, when properly executed, works and how it can be beneficial for savers in

certain instances.

First, it's worth noting that a backdoor Roth is only appropriate for those who earn

too much to contribute to a Roth the conventional way: For 2010, the maximum

adjusted gross income cutoff for married couples filing jointly is $177,000 and the

income limit caps out at $120,000 for single filers. If your household's income is

below those thresholds, you can get into a Roth through the front door.

But assuming that your income is higher than that, you can take advantage of the

fact that beginning in 2010, there are no longer any income limits on who can

convert a traditional IRA to a Roth. Don't ask me why Congress has left open this

gaping loophole, because it doesn't lead directly to new tax revenues, but for now

it provides a way for higher-end investors to get new assets into a Roth.

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Say, for example, a 55-year-old with an adjusted gross income of $185,000 and no

other traditional IRA assets puts $6,000 into a traditional nondeductible IRA. (The

"nondeductible" piece means that his contribution consists of money that has

already been taxed; he can't deduct his contribution on his tax return because he

earns too much.) He could then immediately convert that IRA to a Roth, thereby

ensuring tax-free withdrawals on that money in retirement.

Normally, the big hitch with an IRA conversion is that converters owe taxes on the

part of their IRAs that haven't been taxed yet such as any deductible contributions

or investment earnings, including money rolled over from a traditional 401(k). But

assuming the backdoor converter doesn't see the value of his IRA shoot up

between the time he opens his account and the time he converts, his tax bill on

the conversion would be minimal or even zero. That's because he already paid

taxes on his contribution, and he'll have limited to no investment gains on which

he'll owe taxes at that point. In addition to avoiding taxes on the conversion, he'll

also have gotten some of his retirement assets into the tax-free withdrawal

column, which is beneficial for people like him who have, up until now, earned too

much to contribute to a Roth IRA.

The Maneuver Gone Awry

Remember, however, that the above example hinged on the fact that the backdoor

IRA converter had no other traditional IRA assets. But let's take a look at another

example--one with other IRA assets in the mix--to illustrate how setting up a

backdoor IRA can spell extra taxes.

Let's assume a 32-year-old woman who earns $200,000 a year and has $20,000

in traditional IRA assets puts $5,000 into a traditional nondeductible IRA, seeking

to take advantage of the backdoor conversion option. At first blush, it seems like

this converter shouldn't owe any taxes, either. Her contribution to the new IRA, as

in the previous example, was already taxed, and if she makes the conversion right

away, before her investment goes up in value, she wouldn't owe any taxes on

investment gains, either.

But here's where the tax pain comes in. Her other traditional IRA assets consist

entirely of money that she had rolled over from an old 401(k) plan, meaning that

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2 of 6 4/7/2014 11:08 PM

money has never been taxed. (With traditional 401(k)s, you're not taxed upon

your initial contribution and you're not taxed on your investment gains until you

begin taking money out.)

Because of those other IRA assets, the tax she'll owe upon conversion will depend

on percentage of taxable versus tax-free assets in all of her IRA accounts, not just

the one she just opened.

In her case, $20,000 of her IRA assets haven't yet been taxed totals and her new

nondeductible IRA contribution of $5,000 already has. That means that 80%, or

$4,000, of her recent $5,000 contribution would be taxable upon conversion; only

$1,000 (the other 20%) would not be.

All of this means that if you have other traditional IRA assets, or SEP and SIMPLE

IRAs, you'll need to proceed carefully before opening up a traditional nondeductible

IRA with an eye toward immediately converting to a Roth. This maneuver can work

beautifully for those with no other IRA assets, but it can be a tax headache with

those who do. Check with a tax advisor before proceeding. You may also be able to

conduct a series of partial conversions over a period of time, thereby limiting the

tax hit in any one year.

It's also worth noting that you have an escape hatch if you would like to do a

backdoor IRA but have other IRA assets that you've rolled over from a previous

employer's 401(k). Assuming your new employer also has a 401(k) plan that

allows you to do so, you could roll the IRA assets into that plan, thereby reducing

or eliminating the taxes owed upon conversion of a new backdoor Roth. Of course,

the merits of this strategy will depend entirely on the quality and fees associated

with the new plan.

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Comments 1-10 of 23 CommentsOldest First | Newest First

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4 of 6 4/7/2014 11:08 PM

Berel55

Mar 17 2014, 5:10 PM

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0LikeLike

Do you have to consider an inherited IRA as well..

Berel53

LawyrsGunsNMony

Mar 6 2013, 7:33 PM

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0LikeLike

Renting in NYC, I'm considering this:

After you retire, move to an income tax free state, become self

employed (your business doesn't need to earn any real money) &

start up an individual 401(k) with a fund company such as TRP which

will allow you to roll all your IRA $ into the individual 401(k), then

Roth it all. If you can stand living in your tax free state for more

than a year you could do this over several years to stay in a low

bracket. To avoid any delays you could start your business the year

b4 you retire.

If you own your house & want to keep it, renting it out shouldn't be

a big deal.

ddfell

Apr 18 2012, 11:39 PM

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I think the key is, if you have several IRAs and only one - or some-

of them are non-deductible, you could potentially get quite a tax bill

from Roth conversion. Basically it depends on the total "basis" you

have in non-deductible IRAs and what percentage that is of your

total IRA dollars (across all accounts). But if the non-deductible IRA

is your only IRA or has a significant portion of your total IRA funds -

it might be workable. Playing with Form 8606 can give you a pretty

clear picture of how it will play out.

dragonpat

Feb 14 2011, 5:19 PM

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"O.K., say you do this. What happens next year? Can you contribute

to the Roth you created even though your income is over the limit?

or do you have open a new IRA every year and then convert it to

another Roth? "

The nondeductuble IRA that I cleaned out in 2010 by converting the

contents to a Roth was still there with zero in as of Jan 1, 2011 at

WellsTrade. I just put $6000 in it in Jan 2011 and I am filling out the

paperwork to clean it out again and convert it to the Roth I Opened

in 2010. I did not have to open any new IRAs in 2011.

rar456

Feb 14 2011, 2:46 PM

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0LikeLike

O.K., say you do this. What happens next year? Can you contribute

to the Roth you created even though your income is over the limit?

or do you have open a new IRA every year and then convert it to

another Roth?

dragonpat

Feb 14 2011, 1:54 PM

Flag

"My understanding is that, tax accountant conversations with the

IRS have indicated that they will not allow back door Roth

conversions in the same year as the non deductible IRA deposit"

What IRS ruling or publication covers this belief of your accountant?


5 of 6 4/7/2014 11:08 PM

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Rohit33410

Jan 6 2011, 12:37 PM

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0LikeLike

I deliberately did not convert my old company's 401(k) into an IRA

because I had intended to convert my non deductible IRA into Roth -

which I did.

Question to Christine - if in a future year I convert my 401(k) into

IRA is there any tax consequence for having converted a past (2010)

non deductible IRA into Roth?

drzaius17

Jan 5 2011, 7:31 AM

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0LikeLike

i'm looking at 8606, and maybe i'm not doing it right, but the

example given doesn't seem right, if the woman is converting all her

assets. if the womans 20k is from 401K rollover, then she obviously

pays taxes on it. her ira basis is 5000 from 2010 contribution, as the

rollover is not included in her basis. assuming she converted 5000 at

no loss/gain, then she converted 25000 to roth (line 8). 5000/25000

is 0.2. line 11=25000 x 0.2 = 5000 = non taxable portion of

conversion. in part 2 you redundantly do the same math. line 16 is

line 8= 2500 then you subtract the 5000 on line 17 (same as line

11). she pays taxes on the 20000 from the rollover, but not

necessarily more on backdoor roth.

did i do this right?

Rathgar

Jan 4 2011, 10:57 AM

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0LikeLike

Great article. Also Yogi knows his stuff !

Fee-OnlyAdvisor

Jan 4 2011, 9:56 AM

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0LikeLike

My understanding is that, tax accountant conversations with the IRS

have indicated that they will not allow back door Roth conversions in

the same year as the non deductible IRA deposit.

1-10 of 23 CommentsOldest First | Newest First


6 of 6 4/7/2014 11:08 PM

Backdoor Roth IRAs Could Cost Some Investors at Tax Time

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