The Tax Consequences of a "Backdoor" Roth IRA
When you have multiple traditional IRAs with a mix of pretax and after-tax contributions, converting some of that money into a Roth IRA can complicate taxes.
Question: I’d like to roll over some money from my old 401(k)s into an IRA to make it easier to keep track of my investments. But I heard that the rollover could hurt my ability to make a “backdoor Roth IRA contribution.” What is that, and is it a good reason not do a rollover?
Answer: If you earn too much money to contribute to a Roth IRA, there’s another way to get into this tax-advantaged account: You can contribute to a traditional IRA and then convert the money to a Roth soon afterward, which is called a “backdoor IRA contribution.” (There are no income limits on conversions.)
If your traditional IRA contribution was not tax-deductible and that is the only money you have in a traditional IRA, your conversion to the Roth would be essentially tax-free. You would only have to pay ordinary income taxes on any earnings in the IRA between the time you made the contribution and when you converted to the Roth.
But the tax calculation becomes more complicated if you have other money in traditional IRAs that is a mix of pretax contributions – say, rollovers from a 401(k) -- and after-tax contributions. Your tax liability on a conversion will be based on the percentage of your overall balance that hasn’t been taxed yet. And you can’t pick and choose which money to convert. Say you have $10,000 total in all of your traditional IRAs and $8,000 of that is from rollovers, tax-deductible contributions or earnings, while $2,000 is from nondeductible contributions. Under the formula, 80% of the money converted to a Roth would be taxable, and 20% would be tax-free.
Be aware that any money you roll over from a pretax 401(k) to a traditional IRA will increase the total IRA balance used in the calculation and could cause you to pay taxes on a larger percentage of any conversion. For example, if your traditional IRA balance is $20,000 after rolling over money from a 401(k) and $2,000 is from nondeductible contributions, only 10% of any conversion to a Roth will be tax-free, and the remaining 90% will be taxable.
You can contribute to a Roth IRA directly for 2018 if your income is below $135,000 for single filers or $199,000 if you’re married filing jointly (the contribution amount starts to phase out for single filers earning $120,000 or more and joint filers earning $189,000 or more). You have until April 15, 2019, to contribute to a Roth IRA for 2018. But if you earn more than the cutoff and you want to make a back-door Roth contribution, it’s important to consider the total balance in your traditional IRAs when calculating the tax ramifications. See my column You Can Contribute More to Your 401(k) in 2018 for more information about the income levels to qualify to contribute to a Roth IRA and to make tax-deductible traditional IRA contributions for 2018.