The Potential Tax Hit When High Earners Convert to a Roth IRA
High earners using a "backdoor" strategy to open a Roth IRA can trigger taxes if they own other IRAs.
Question: I'm thinking of simplifying my finances by rolling over money from my old employers' 401(k)s into a traditional IRA. But would that make it harder to do a backdoor Roth IRA contribution? I'm above the income limits to contribute directly to a Roth IRA and was considering making a nondeductible contribution to a traditional IRA and then converting it to a Roth.
Answer: Yes, you're right—rolling over more pretax money from your 401(k)s into a traditional IRA would affect your tax liability if you make a "backdoor" Roth IRA contribution. Some people use the backdoor Roth strategy when they earn too much to contribute directly to a Roth IRA; they instead contribute to a traditional IRA and then convert that traditional IRA to a Roth (see How High Earners Can Set Up a Roth IRA for more information).
The backdoor is wide open if you have no other money in a traditional IRA. You could make a nondeductible contribution and then convert the account to a Roth. Assuming no earnings before the conversion, the transaction would be tax-free.
But, if you had any pretax money in a traditional IRA (from deductible contributions, a rollover and earnings), part of any conversion would be taxed, based on the ratio of nondeductible money in the account to the total balance of all your traditional IRAs. Let's say you have no IRA prior to rolling over $100,000 from a 401(k) to a traditional IRA. You then make a nondeductible $5,000 contribution and convert the same amount to a Roth. Since $5,000 is about 5% of the $105,000 in the account, only about 5% of the conversion would be tax-free. The other $4,762 would be taxed.
Given the tax bill, it's best to postpone rolling over your 401(k) money into an IRA until after you convert your traditional IRA contribution to a Roth using the backdoor strategy.
For more information, see How to Contribute to a Roth IRA if You Earn Too Much. See What You Need to Know About Making IRA and 401(k) Contributions in 2017 for the income limits.