The Roth IRA is a popular retirement account in which after-tax contributions are made, and then withdrawals in retirement are tax free. This type of account is popular for good reason, it has some compelling perks:

  • After contributions are made, your money grows tax free and all qualified distributions in retirement are tax free.
  • You can withdraw your contributions at any time.
  • Certain IRS exceptions allow you to take distributions prior to retirement.  One of these exceptions is for first time home buyers who are allowed to withdraw up to $10,000.

This a great type of retirement account for many people, but not everyone is allowed to contribute directly to a Roth IRA due to income limitations. You may only contribute to a Roth IRA if you make less than a certain amount of money: $137,000 for single filers and $203,000 for married couples filing jointly in 2019.  

If your income level exceeds these limits, you cannot contribute directly to a Roth IRA.  But don’t worry, there is a way to get around the income limits and still get money into a Roth IRA.  You can contribute to a traditional IRA and then convert some or all of that money to a Roth IRA. This is known as a Roth IRA conversion, or a “backdoor” Roth.

Previously, only individuals with an income of less than $100,000 were allowed to make Roth conversions.  But in 2010, congress changed the rules to allow anyone to make a conversion regardless of their income level.        

HOW ROTH CONVERSIONS WORK

Here’s how it works.  If you have a traditional IRA, and you decide that you would like to convert some of it to a Roth IRA, a distribution is taken from the traditional IRA and is changed into a Roth IRA.  As long as the conversion to Roth is made within 60 days of the money coming out of the traditional IRA, you avoid the 10% IRA early distribution penalty. This is usually not an issue because the whole conversion process is usually carried out all at once by the financial institution holding your IRA.

This all sounds pretty great, but here’s the catch:  Since a traditional IRA is usually made up either partially or completely of pre-tax money, when you convert to Roth status, you have to pay income taxes on the taxable portion of that money.  If the IRS didn’t make you pay tax on the conversion of pre-tax dollars to Roth status, you would be getting away with never paying any tax on your contributions or earnings. And of course, the IRS has rules that prevent you from getting away with anything that sweet.

DEDUCTIBLE AND NON-DEDUCTIBLE  IRA CONTRIBUTIONS

Before getting into the way these conversions are taxed, lets just review the two types of traditional IRA contributions.  

For most people, contributions are tax deductible. That means that the amount of your contribution can be deducted from your income, lowering your tax bill for the year.

Some higher income earners cannot deduct their traditional IRA contributions, in this case, non-deductible contributions are made.  If you make a non-deductible IRA contribution, IRS form 8606 must be filed with your taxes. This allows the IRS to keep track of which contributions are deductible and which are not. You’ll see why the distinction between deductible and non-deductible contributions is important in the next section.

TAXATION

There are four taxation situations which will cover most Roth IRA conversion scenarios.

1 – If all of your contributions to your traditional IRA have been tax deductible it’s really simple: the whole amount that you convert is taxable.

2 – If all of your contributions to your traditional IRA have been non-deductible and you have no earnings (interest/investment returns) on the contributions, you do not have pay any taxes on the conversion since you have already paid the income tax on your contributions.

3 – If all of your traditional IRA savings have been non-deductible and you do have earnings on the contributions, you only have to pay tax on the earnings portion:

Example: Joe has a traditional IRA.  He has made $40,000 of non-deductible contributions.  He has $10,000 in investment gains, bringing the total balance to $50,000.  He decides to convert the entire traditional IRA to a Roth IRA. Joe will only have to pay income tax on the $10,000 of earnings.  The $40,000 of non-deductible contributions are not taxed (he has already paid income tax on the money that made up his contributions).

4 – In this last scenario it gets a little more complicated.  What if you have a mixture of deductible contributions, non-deductible contributions and earnings and you want to convert a portion of your traditional IRA to Roth?  If you are going to convert some amount money to Roth and want keep the rest in your other IRAs, you can’t just convert your non-deductible contributions and get away with paying no tax.  You have to use the “pro rata” rule to figure out what proportion of all of your IRA funds are taxable and non-taxable.

Example: Susan has a $10,000 traditional IRA that she wants to convert to a Roth IRA. She has a total balance of $100,000 in all of her IRAs combined.  The $10,000 she wants to convert is the only non-deductible money, the other $90,000 is composed of deductible contributions and earnings. Susan can not just convert the non-deductible $10,000 and pay no taxes.

Since 90% of her total IRA balance is made up of deductible contributions and earnings, then 90% of her conversion will be taxable.  Susan will have to pay income tax on $9,000 of the $10,000 conversion.

Now you can see why it is important for you and the IRS to keep track of which IRA contributions are deductible and which are non-deductible with form 8606.  You need that information to figure the taxable amount of a conversion. Form 8606 also must be completed when you do a Roth conversion to make sure you are taxed correctly on the conversion.

STRATEGY TO AVOID PRO RATA TAXATION

As you probably noticed in situation #4 above, this pro rata rule can make conversions expensive if most of your IRA balance is from deductible contributions.  Luckily, there is a way to get around the pro rata rule if you find yourself in this situation and want to start making Roth conversions.

Since the pro rata rule is based on the value of your IRA accounts only, you can get around the rule by rolling over all of your IRA funds into your 401(k) if you have one.  This eliminates your IRA balances and wipes the slate clean.  After you make that rollover into your 401(k), you can make non-deductible contributions to an IRA and immediately convert them to a Roth IRA without having to pay any additional tax on the conversion.

This strategy is not appropriate for everyone, so make sure you consult with a financial professional before considering this strategy.

WHY DO A ROTH IRA CONVERSION?

Why would you want to do a roth conversion in the first place?  If your income is high enough to disqualify you from direct Roth contributions, you’ll probably be better served by getting your tax break now by making tax deductible IRA contributions.  So why even consider doing a Roth IRA conversion?

  • If you expect your income to drop significantly in a particular year and then go up to normal again, you can plan a Roth conversion in the low income year.  With lower income that year, you will potentially be in a low tax bracket and will be taxed at a very low rate on your conversion. Then after you have completed the conversion, you know that you never have to pay any more tax on that converted amount again, regardless of how low your tax rate was in the year of the conversion.  This is a nice way to reduce your total tax liability if you have income that may fluctuate from year to year.
  • Another reason is for tax diversification.  Since we really have no idea what the income tax rates will be in 30 or 40 years from now, many people feel that it is a good idea to have some retirement funds available that will be taxed and other funds that will not be taxed in retirement.  In the future, the tax rates could conceivably be much higher or much lower than they are now, so this is a hedge against the possible variability of future income tax rates.
  • If you expect that your tax rate during retirement will be significantly higher than it is now, a Roth IRA conversion could make sense from a tax perspective.

CAN YOU AFFORD A ROTH IRA CONVERSION?

Before converting, remember that you have to be able to afford the taxes.  If your income is lower one year, it could make good sense from a tax perspective to make a sizable conversion that year.  But with a lower income, it might be hard to pay the taxes you owe on the converted money. The conversion can sometimes look great on paper, but making that tax payment can be a tough pill to swallow.

In order to determine if a conversion is worthwhile, assumptions have to be made about your future income and income tax rates.  Since we have no way of knowing this information for sure, it can be a difficult decision to make. As you can see, there are a lot of factors that need to be taken into account.  Alternate tax strategies should be considered before making a conversion. Make sure you consult with a financial advisor if you are considering a roth conversion.

QUICK SUMMARY OF KEY POINTS

  • A Roth IRA conversion is a way to get money into a Roth IRA account if you are disqualified from making direct Roth IRA contributions due to your income.
  • A Roth IRA conversion is a taxable event.  You may owe income tax on some, or all of your conversion.
  • You cannot choose to only convert the non-deductible contributions in your IRA if it also contains deductible contributions.
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