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Don't Let These Rules Slam Your Backdoor Roth Conversion

By Dan Caplinger - Dec 21, 2020 at 12:32AM

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It can be tricky to know how and when to convert a traditional IRA into a Roth IRA.

Roth IRAs are great, but not everyone is able to contribute to them directly. That's where backdoor Roths come in, where you make a contribution to a traditional IRA and then immediately convert it to a Roth. The rules for backdoor Roth IRAs are a little confusing, though, and it's difficult to know how they might apply to your situation. In this video from an October installment of the Motley Fool Live "Financial Planning Power Hour" series, longtime contributor and Director of Investment Planning Dan Caplinger discusses the ins and outs of the backdoor Roth and what you need to know in order to use it.

Robert Brokamp: Backdoor Roths can be a great way for people who earn too much to contribute to the Roth IRA, to get money into a Roth IRA. However, you have to pay attention to the pro-rata rules. Dan, tell us about those.

Dan Caplinger: You bet. We get lots of questions about this every week, and I got one too many, I got to look back, I got to make sure I know what the rules are.

Here's what the general deal is: the idea of the backdoor Roth is, for whatever reason, the IRS does not allow people to make a direct contribution to a Roth IRA if their incomes are above certain threshold amounts. What they will let people do though, is make regular, traditional IRA contributions and then convert them into a Roth IRA. No income limits on Roth conversions.

Most people who have incomes that are high enough not to be able to make direct Roth contributions also have incomes that are high enough that they generally can't make deductible contributions to a regular traditional IRA. They have to make contributions that are not tax-deductible. These nondeductible contributions are useful in terms of Roth conversions because if you convert a nondeductible traditional IRA, if you convert that to a Roth, then you get credit for the after-tax money that you put into the account.

Now, here's what the problem is, and this is where all these pro-rata rules come in. If you have traditional IRA money, some of which is non-deductible after-tax money, and some of which is deductible pre-tax money, the IRS does not let you just pick and choose the after-tax money for your conversion. You have to do the pro-rata rule.

The way that the IRS does this is, they take a look at your account balances as of December 31 of the year that you are making the conversion. This is something that's actually tripped me up. I thought it was as of the date of the actual conversion, but it's not, it's as of December 31.

So we've gotten lots of questions about, what if I do this first? What if I do this later? What if I do something out of order? What's the impact? The magic date to look at is December 31, so if you can get yourself in a position where you have no regular deductible traditional IRA money as of December 31, and then you do the conversion of the non-deductible amount, then you're in a position where you're not going to have to pay extra tax on the conversion, and that's where you want to be.

Some other questions we've gotten have to do with, what kinds of IRAs do you look at? It turns out you look at not only traditional IRAs, just the regular retirement accounts that anybody can open, you also look at some of these simplified retirement plans, like SEP IRAs and simple IRAs. You have to take a look at that too.

So if all of your regular traditional IRA money is nondeductible, but you had some pre-tax money in these simple or SEP IRAs, you're going to have to add those up, you're going to have some pro-rata issues.

Now, the fun thing is that the rules are not the same for money that's in a 401(k). If you're fortunate enough to have a 401(k) plan that allows you to put in both pre-tax money and after-tax money into the 401(k), the IRS specifically allows you to say, hey, I just want to convert the after-tax 401(k) money to a Roth. That's totally fine, because it's coming from the 401(k).

But if it goes from the 401(k) to a traditional IRA through a rollover first and then you do the conversion, you just blew it. You lost the ability to segregate out that after-tax money, you're going to have to do in the pro-rata rule. So hopefully that's a quick perimeter on how this works. I know there's complications, other questions, feel free to ping them up in the box, but hopefully that will give you a hint on how to get these backdoor Roth conversions moment as the end of the year approaches.

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