The backdoor Roth strategy is a great tool for high income earners to stash away extra retirement savings, tax-free. However, there’s a little known rule that complicates this, known as the aggregate, or pro-rata rule. This video breaks down the rule and identifies the types of situations it might apply.

DISCLAIMER: While the information expressed in this video is believed to be accurate, this video is not specific tax, legal or investment advice. Before considering acting on anything you see in this video, first consult with your tax, legal or investment advisor….(read more)

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The Backdoor Roth IRA is a strategy that allows high-income individuals to contribute to a Roth IRA, even if they are not eligible to make direct contributions due to income limits. However, there is a potential pitfall in the form of the Aggregate/Pro-Rata Rule, which can limit the benefits of the Backdoor Roth strategy.

The Backdoor Roth IRA works by making a non-deductible contribution to a traditional IRA and then converting that contribution to a Roth IRA. Since there are no income limits for making non-deductible contributions to a traditional IRA, this strategy allows high-income individuals to effectively bypass the income limits for Roth IRA contributions.

However, the Aggregate/Pro-Rata Rule comes into play when an individual has both pre-tax and after-tax funds in their traditional IRAs. When making a conversion from a traditional IRA to a Roth IRA, the IRS looks at the aggregate balance of all traditional IRAs to determine the tax implications. This means that if an individual has both pre-tax and after-tax funds in their traditional IRAs, the conversion will be subject to taxes based on the proportion of after-tax funds in the aggregate balance.

For example, if an individual has $100,000 in pre-tax funds and $10,000 in after-tax funds in their traditional IRAs, any conversion to a Roth IRA will be subject to taxes on 91% of the converted amount, reflecting the proportion of pre-tax funds in the aggregate balance.

This can significantly undermine the benefits of the Backdoor Roth strategy, as the tax implications of the conversion may outweigh the potential tax benefits of a Roth IRA. To mitigate this issue, some individuals choose to roll over their pre-tax funds in their traditional IRAs to an employer-sponsored 401(k) plan, which can separate the pre-tax and after-tax funds and allow for a clean conversion to a Roth IRA.

It’s important for individuals considering the Backdoor Roth strategy to be aware of the Aggregate/Pro-Rata Rule and its potential impact on their tax situation. Consulting with a financial advisor or tax professional can help individuals navigate the complexities of the Backdoor Roth strategy and make informed decisions about their retirement savings.

In conclusion, while the Backdoor Roth IRA can be a valuable tool for high-income individuals to access the benefits of a Roth IRA, the Aggregate/Pro-Rata Rule presents a potential challenge that must be carefully considered. Understanding the implications of this rule and taking steps to manage its impact can help individuals make the most of the Backdoor Roth strategy and optimize their retirement savings.