Backdoor Roth contributions are a common strategy we use with high-income professionals who exceed the annual income limits to contribute directly to Roth accounts. Using a backdoor Roth strategy allows them to get extra savings into Roth for tax-free compounded growth for life.

Unfortunately, when super-savers come to us after attempting a Backdoor Roth contribution on their own, a common mistake arises time and time again – forgetting to fully clean out an IRA of all pre-tax dollars before executing the strategy. Why is this important? A critical statute known as the pro-rata rule can cause you to pay more taxes than necessary on the Backdoor Roth strategy if you aren’t meticulous about every step along the way.

What is the Pro-Rata Rule for a Backdoor Roth?

For the Roth Conversion step when performing a Backdoor Roth contribution, the pro-rata rule says that all IRAs are treated as one IRA. This means that any funds converted to Roth will be taxed proportionally according to the amount of pre-tax and non-deductible funds subject to the conversion, incurring the risk of double taxation. Learn more here:

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Video highlights:
00:19 – How does the backdoor Roth strategy work
01:10 – The most common mistake
02:42 – How do we fix this mistake?

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713.439.1200
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Disclosures:
Willis Johnson & Associates is a registered investment advisor. The information presented is for educational purposes only. It should not be considered specific investment advice, does not take into consideration your specific situation, and does not intend to make an offer or solicitation for the sale or purchase of any securities or investment strategies. Investments involve risk and are not guaranteed. Be sure to consult with a qualified financial advisor and/or tax professional before implementing any strategy discussed herein. WJA is not endorsed by or affiliated with Chevron. Corporate benefits may change at any point in time. Be sure to consult with human resources and review Summary Plan Description(s) before implementing any strategy discussed herein. Willis Johnson & Associates is not a CPA firm….(read more)

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How the Pro Rata Rule Can Cost You Additional Taxes on Your Backdoor Roth Conversion

One of the popular strategies used by high-income earners to contribute to a Roth IRA is called a backdoor Roth conversion. This method involves contributing to a traditional IRA and then converting it to a Roth IRA. However, if you already have funds in a traditional IRA, the IRS’s pro rata rule can potentially result in additional taxes on your backdoor Roth conversion.

The pro rata rule is a tax regulation that comes into play when you have both pre-tax and after-tax funds in a traditional IRA. If this is the case, any distribution or conversion made from the IRA will be subject to taxes based on the proportion of pre-tax funds in the account. The rule aims to prevent individuals from evading taxes by only converting their after-tax contributions to a Roth IRA.

Let’s consider an example to understand how the pro rata rule works. Suppose you have $100,000 in a traditional IRA, consisting of $80,000 in pre-tax funds and $20,000 in after-tax contributions. You decide to convert $10,000 to a Roth IRA. According to the pro rata rule, 80% of the conversion amount, or $8,000, will be subject to taxes since 80% of your traditional IRA balance is pre-tax funds. Only the remaining $2,000 will be considered tax-free. Consequently, you will owe taxes on the $8,000 at your ordinary income tax rate.

This rule can catch many individuals off guard, as they may assume that the basis of their after-tax contributions can be converted tax-free. However, the pro rata rule treats all funds in your traditional IRA as a single entity when determining the taxability of your conversion. Therefore, having other pretax funds in your traditional IRA will affect the tax treatment of your backdoor Roth conversion.

To avoid any surprises, it is crucial to carefully consider the tax implications before executing a backdoor Roth conversion. If you already have pre-tax funds in a traditional IRA, it may be beneficial to explore other options to reduce the impact of the pro rata rule.

One potential strategy is to take advantage of your employer-sponsored retirement plan. If your employer’s plan allows it, you can roll over your pre-tax funds from the traditional IRA to the employer plan. By doing so, you eliminate these pre-tax funds from the equation, and only the after-tax contributions will be subject to taxes during the conversion.

Another option is to convert your entire traditional IRA balance to a Roth IRA in one go. This approach works well if you have sufficient funds set aside to pay the taxes that arise from the conversion. By converting the entire balance, you avoid the pro rata rule altogether.

Lastly, if you have no choice but to adhere to the pro rata rule, it is crucial to consult with a tax professional. They can guide you through the process, help you estimate your tax liability, and offer suggestions to mitigate the impact of additional taxes.

In conclusion, while the backdoor Roth conversion offers a valuable strategy to contribute to a Roth IRA for high-income earners, the pro rata rule can complicate matters. It’s essential to be aware of the potential tax implications and explore alternative approaches to minimize taxes or seek professional advice to navigate this complex tax regulation effectively.