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Misconceptions About Backdoor Roth IRA Conversions

In 2014, the income limit for Roth contributions is $129,000 for single filers and $191,000 for married couples filing jointly. For high-income earners who earn too much to contribute to a Roth IRA directly, the only method of getting new assets into a Roth IRA is to go in through the backdoor, opening traditional nondeductible IRAs, then converting those accounts to Roth IRAs. It’s a way for higher-income folks to pay tax now in exchange for tax-free withdrawals of at least some of their assets during retirement. But the maneuver carries some important caveats, so it pays to stay attuned. Here are four of the biggest misconceptions about backdoor Roth IRAs.

Backdoor Roth IRAs Are Always Tax-Free: When you convert the newly opened traditional IRA to a Roth, you’ll owe taxes on any appreciation in your shares since you made the initial purchase if you have no other IRA assets. But if you do hold other IRA assets, you’ll be affected by what’s called the pro rata rule. Under this rule, the IRS looks at your total IRA holdings to determine your tax bill when you do the conversion; the tax you pay depends on your ratio of assets that have already been taxed to those that have not. Let’s say you have $45,000 in a rollover IRA and $5,000 in your new nondeductible IRA. That means your ratio of taxable/tax-free assets in your total IRA is 9/1. Upon conversion of that new $5,000 traditional IRA, you’d owe taxes on $4,500 of income, because 90% of your total IRA pool consists of money that has not been taxed. You’ll run into the same issue if you try to execute a backdoor IRA and you also have traditional IRA assets on which you’ve taken a tax deduction; ditto if you have made nondeductible contributions but a big share of your IRA balance consists of appreciation. In both cases, the pro rata rule would affect the taxes due when you convert.

A Backdoor IRA Should Always Be Off-Limits if You Have Traditional IRA Assets: The preceding example illustrates the tax treatment if you undertake a backdoor IRA and have a lot of money in a traditional or rollover IRA that has never been taxed. If you have a rollover IRA and participate in a company retirement plan that permits it, you can roll that money into the 401(k) before executing the backdoor Roth IRA. In doing so, those dollars wouldn’t be part of the calculation of taxes due under the pro rata rule.

Once You Go Backdoor, You Can Readily Make Additional Roth Contributions: One other common misconception about backdoor IRAs is that once you do one, you can make additional Roth contributions. Unfortunately, this is true only if your income falls below the Roth IRA eligibility thresholds in future years, or if you no longer participate in a company retirement plan. If that’s the case, you can make a Roth contribution outright. All others, however, will have to go through the same motions to make additional Roth contributions, first contributing to a traditional IRA and then converting to a Roth.

All Roth IRAs Give You Easy Access to Your Cash: Flexibility is one of the key benefits to having a Roth IRA. If you make direct contributions (that is, your entry point into a Roth isn’t through converting), you can withdraw your contributions (but not your earnings) at any time without owing tax or a penalty. But if you get into a Roth IRA via conversion, you’re governed by a different set of rules. To avoid the 10% penalty on early withdrawals of the amounts you’ve converted, you need to hold those assets in your Roth IRA for five years, you need to be age 59 1/2, or you need to meet other exceptions.

Funds in a traditional IRA grow tax-deferred and are taxed at ordinary income tax rates when withdrawn. Contributions to a Roth IRA are not tax-deductible, but funds grow tax-free, and can be withdrawn tax free if assets are held for five years. A 10% federal tax penalty may apply for withdrawals prior to age 59 1/2. Please consult with a financial or tax professional for advice specific to your situation.

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