Some financial mistakes announce themselves with a crash of thunder. Others wait quietly in the shadows until tax season. A backdoor Roth IRA can be a useful planning strategy, but when it crosses paths with an IRA rollover, the pro-rata rule may deliver an unwelcome scare. The surprise occurs when other pre-tax IRA assets cause part of the conversion to become taxable.
This is not a story without a happy ending. Understanding what the IRS counts—and when it counts it—can help you spot the trap before year-end.
What is a Roth Conversion?
A Roth conversion moves money from a pre-tax retirement account—such as a traditional IRA—into a Roth IRA. The converted pre-tax amount is generally included in taxable income for that year. In exchange, the money enters a Roth account, where qualified withdrawals can be tax-free. A conversion is different from a regular Roth IRA contribution and is not subject to the income limits that may restrict direct Roth IRA contributions. The conversion itself is not the danger; the surprise often lies in what else is already lurking in your IRA.
Why some investors enter through the ‘backdoor’
When income is too high for a direct Roth IRA contribution, an investor may make a non-deductible contribution to a traditional IRA and then convert that amount to a Roth IRA. This two-step approach is commonly called a backdoor Roth strategy. If the investor has no other pre-tax money in traditional, SEP or SIMPLE IRAs, the taxable portion of the conversion is limited to any earnings on investments between the contribution and the conversion.
The pro-rata rule: When the accounts become inseparable
Picture your non-deductible IRA contribution as chocolate syrup and your pre-tax IRA money as milk. Before they meet, each is easy to identify. Once the syrup is stirred into the milk, every sip contains some of both. This is the same way the pro-rata rule works. Once combined, the pre-tax and after-tax dollars cannot be separated for tax purposes–and that mixture can come back to haunt an otherwise straightforward conversion.
For tax purposes, all of your traditional, SEP and SIMPLE IRAs are generally treated as one combined balance. That total includes pre-tax amounts—such as rollovers, deductible contributions and earnings—and after-tax basis from non-deductible contributions. The nontaxable share of a conversion is based on the ratio of your after-tax basis to the total amount used in the calculation. The remainder is taxable. For example, if only a small portion of your combined IRA balance represents after-tax contributions, only a similarly small portion of the conversion is tax-free.
How a same-year rollover can come back to haunt you
If you convert a non-deductible traditional IRA contribution early in the year and later roll pre-tax money from a 401(k) or another workplace plan into a traditional IRA, the sequence can summon a tax consequence you did not expect. IRS Form 8606 looks at the value of all traditional, SEP and SIMPLE IRAs on Dec. 31, along with the year’s relevant distributions and conversions. A plan-to-IRA rollover that remains in an IRA on Dec. 31 of the year of the backdoor Roth conversion can allow more pre-tax money to creep into the calculation—even if the conversion happened first.
Is there an escape route through your workplace plan?
An escape route may exist, but it has to be addressed before the end of the year. If your current employer’s retirement plan accepts incoming rollovers, you may be able to move eligible pre-tax IRA dollars into that plan before year-end. Amounts held in a qualified workplace plan are not included in the IRA year-end balance used for the pro-rata calculation. Moving eligible pre-tax IRA dollars into your employer’s retirement plan may therefore leave only after-tax dollars in the IRA for the Roth conversion calculation.
Before taking this escape route, the details are important to verify. The workplace plan must permit the rollover, and only eligible pre-tax amounts can move. Moving money into a SEP or SIMPLE IRA won’t eliminate the problem because those balances are still included in the pro-rata calculation. Review the account type, plan terms and timing with your financial and tax professionals before acting.
Five ways to ward off a pro-rata tax surprise
- Take inventory of every account. Include traditional, rollover, SEP and SIMPLE IRAs—not just the account used for the conversion. Opening a separate account for a non-deductible contribution does not protect the conversion from the pro-rata rule.
- Keep a watchful eye on the year-end deadline. If the backdoor Roth strategy is an important priority, consider how moving workplace-plan money into an IRA before Dec. 31 could affect the calculation. Depending on your circumstances, leaving the assets in the plan or completing the rollover in a different tax year may be worth discussing with your advisors.
- Look for a workplace-plan escape route. If a reverse rollover from an IRA to your employer’s retirement plan may be appropriate, ask whether the employer plan accepts incoming IRA assets and what documentation and deadlines apply.
- Keep your tax records. Do not let your after-tax basis vanish into the fog. Keep copies of Forms 8606 and related records so previously taxed dollars can be tracked accurately.
- Call in your team. Keep your financial and tax advisors in the loop so they can help sequence the transactions and model the potential tax results.
One last look over your shoulder
As our Scary Financial Mistakes series comes to a close, the lesson is not to fear executing a desired financial strategy. It is to look carefully at what may be lurking in the details. A backdoor Roth strategy can be useful, but conversions, rollovers and year-end IRA balances can sometimes lead to unanticipated tax results. Review the full picture before the door closes on Dec. 31 so an otherwise thoughtful strategy does not return as an unexpected tax bill.
Disclaimer: This article is for general educational purposes and is not individualized tax, legal or investment advice. Tax rules are complex and may change. Consult qualified professionals about your circumstances before making a contribution, conversion or rollover.
IMPORTANT DISCLOSURES: The information provided is based on internal and external sources that are considered reliable; however, the accuracy of this information is not guaranteed. This piece is intended to provide accurate information regarding the subject matter discussed. It is made available with the understanding that Benjamin F. Edwards is not engaged in rendering legal, accounting or tax preparation services. Specific questions on taxes or legal matters as they relate to your individual situation should be directed to your tax or legal professional.
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