Here’s the big question to ask yourself before starting a “backdoor” Roth IRA strategy. Do you already have other IRAs? In this video, Forbes Best-In-State wealth manager Cary Stamp, CFP® explains how the Backdoor Roth Pro-Rata Rule impacts the tax efficiency of the backdoor Roth IRA, and provides the potential solution!
I’m Certified Financial Planner Cary Stamp. This is going to be a Principled Wealth Moment on what to watch out for when you’re doing the backdoor Roth IRA.
A lot of financial advisors, myself included, think Roth IRAs are phenomenal vehicles for growing tax-free money over a long, long period of time. However, there’s one pitfall you need to be aware of before you execute this strategy and that is what’s called the pro-rata rule. What does a pro-rata rule say? The pro-rata rule says that if you already have an existing IRA and you execute the backdoor Roth IRA strategy, you don’t actually get to do the conversion of what you’re contributing in a given year and have it be completely tax-free conversion.
With an IRA, we get a tax deduction if we meet certain income thresholds. Most of the people doing the backdoor Roth are not taking a tax deduction for their annual IRA contribution. That IRA contribution is usually $6,000. So people think I put my $6,000 into my traditional IRA, I convert it shortly thereafter to my Roth IRA, and there’s no tax liability. Well, that might be true, but the first question you need to ask is, do you have other IRAs? And if you do, how much is in your other IRAs?
I’m going to make the math easy for myself and say that I’ve got a client that wants to make a $6,000 annual contribution. He wants to do that to a traditional IRA, is not going to take the tax deduction because he wants to do the backdoor strategy. The $6,000 annual contribution goes into his IRA, but he or she has a current IRA of $54,000. Now, the pro-rata rule says that the only portion of the amount that you convert that you can exclude is the same percentage of the total that you have in all of your traditional IRAs.
So let’s walk through that step by step. We make a $6,000 contribution to the IRA. In this case, I said that there was already $54,000 in there… just trying to make the math easy myself. So it’s a total of $60,000 that’s in these two IRAs. Well, $6,000 is 10% of $60,000. So if this person wants to do the backdoor strategy and they do the conversion, they’re going to pay tax on 90% of the amount that they convert. So if they turn the $6,000 from traditional to Roth IRA and they have this other IRA in existence, hello… you’re getting a tax bill and you’re going to pay it on $5,400, the amount that you’re converting. Watch out for this one, folks.
Hey, is there a way around this? You know, I get that question a lot. And the answer is, of course there is. Don’t have other IRAs. How can you eliminate the other IRAs that you have? One, you can convert them all to Roth, which means you might be paying a bunch of tax on the conversions that you’re making, but it’s a possibility. Or two, you can roll the money that you currently have into IRAs, into your employer-sponsored retirement plan, or if you’re self-employed, into your own individual 401k plan. Once you’ve eliminated all of the IRAs that you have and moved them into a retirement plan, then the backdoor Roth strategy works without a hitch.
If you have questions, give us a call. I’m Cary Stamp, and this has been a Principled Wealth Moment.