By Allen Giese, ChFC®, CLU®
I received two calls this past month asking basically the same thing. “Hey, Allen, I was talking to this guy, and he said I should do a backdoor IRA. It sounded great! What do you think?” My first thought was “Is someone out there doing seminars on this?”
It reminded me of a word that I learned many years ago: Tinstaafl. There Is No Such Thing As A Free Lunch. Or put another way, if it sounds too good to be true, it probably is.
Not that backdoor IRAs are too good to be true. They are actually a legitimate way to put money into a Roth IRA, even if your income is above the earnings threshold to contribute. But as is often the case, the ways things are sometimes described around the water cooler is too good to be true.
It’s important to first understand what a Roth IRA is. Roth IRAs allow you to grow money tax-free and take distributions upon retirement with zero tax liability. So you put money in after-tax, but from that point on, you’ll pay no income taxes on the earnings—even when you take them out.
Roth IRAs also avoid the required minimum distribution (RMD) rules that kick in after age 70, which many consider to be a bonus. But the problem is that the ability to contribute to a Roth IRA is based on your earnings, and once your modified adjusted gross income (MAGI) crosses $122,000 for single filers or $193,000 for married filing jointly, a Roth contribution is no longer an option.
However, when you convert traditional IRA money to a Roth IRA, there are no such income limits to be concerned with. You could be making a million dollars a year and still convert your IRA money to a Roth. All you have to do is pay the income tax on the amount you convert. So if you look at it from the IRS’s perspective, of course they would like you to convert, especially if you are in a higher tax bracket like a person earning a million dollars a year would be!
So now “this guy” says, “Well, that’s where the backdoor IRA comes in. You make an after-tax contribution to your IRA (as long as you are under age 70 ½) up to the contribution limit ($7,000 in 2019 if you are over 50) and then convert $7,000 to your Roth in the same year. Voila! At the end of the day, you have made a Roth contribution for $7,000 through this loophole those buffoons at the IRS didn’t see.”
Sounds too good to be true?
Actually, everything he said is true—except maybe for the “buffoons at the IRS” part. But he’s leaving out an important detail. That detail is this rule the IRS has called the “pro-rata rule,” because, yes, they did see this one coming. The rule is how the IRS accounts for after-tax and pre-tax funds in an IRA when the taxpayer is doing a partial Roth conversion.
The formula for the pro-rata calculation is the total after-tax money in all IRAs divided by the total value of all IRAs multiplied by the amount converted. Huh? OK, here’s an example. Let’s say you make a $7,000 non-deductible contribution to an IRA that you want to convert to a Roth this year. Let’s further assume you also have a rollover IRA worth $100,000.
When you convert the $7,000 to a Roth, only $458 will be considered after-tax ($7,000 / $107,000 = 6.54%; $7,000 x 6.54% = $457.80). The remaining amount, $6,542, will be considered pre-tax. Because of this rule, you’ll have to pay income tax on the $6,542.
The pro-rata rule forces you to consider all IRAs when you do this calculation, but you don’t have to include your spouse’s IRAs if you are filing a joint return.
Is it still a good idea to consider a Roth IRA conversion? It could be based on your unique circumstances, but understanding the pro-rata rule can make a big difference in how you look at it. If it’s something you’d like to discuss with your Northstar advisor, well, that why we’re here!