Roth IRAs are powerful retirement saving vehicles. They allow you to save money on an after-tax basis during your working years and then take tax-free withdrawals at retirement as long as you're at least 59-1/2 years old and opened the account at least five years prior. If your income is above a certain limit, then you're prohibited from making contributions to these accounts -- but Congress was nice enough to provide taxpayers with a loophole they can use to get around this rule.
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In 2010, Congress removed the income restriction on Roth IRA conversions, which means that you can now convert any amount of money in a traditional IRA or other qualified plan to a Roth IRA in a single year without having to worry about exceeding the income limit. This opens a "back door" to the Roth IRA for retirement savers whose incomes are too high to allow them to contribute to directly. They can now fund a Roth IRA by making a contribution to a traditional deductible or nondeductible IRA and then simply converting the balance to a Roth IRA each year. (They can also fund a Roth IRA by converting a qualified plan from a former employer to a Roth account.)
For example, if you are a single filer and you make more than $133,000 in 2017, you will be disallowed from making a direct contribution to a Roth IRA this year. But you can open a traditional IRA, contribute $5,500 (or $6,500 if you are age 50 or older) and then convert this amount into a Roth IRA. This strategy is especially appropriate if you are a high-income earner who participates in a qualified plan sponsored by your employer, as you are also most likely (though not automatically) ineligible to make deductible traditional IRA contributions because your income is too high. If your income is too high to make a deductible IRA contribution, then you lose nothing by taking an additional step and converting your nondeductible contribution into a Roth account each year (although you may owe tax on some or all of the contribution amount-see below).
Calculating taxable income
Any traditional IRA or qualified plan balance that was funded entirely with deductible contributions will be fully taxed on 100% of the balance if you convert it to a Roth IRA. Therefore if you fund a traditional IRA with a deductible contribution, the full amount of this contribution will be taxed if you convert it to a Roth IRA. But the rules get more complicated if you have multiple traditional IRAs.
If you have more than one traditional IRA, then the IRS aggregates all the funds across those accounts for the purposes of withdrawals or contributions. Any money you convert is spread across the accounts on a pro-rata basis. In other words, if you have a nondeductible traditional IRA and a deductible traditional IRA, then you can't convert only the nondeductible account to a Roth IRA in order to avoid paying taxes on the converted amount.
In order to comply with the IRS rules, you must start by figuring out what percentage of your converted IRA money is taxable. To do this, simply divide the amount of your deductible IRA funds by your total traditional IRA funds. As an example, let's say you have $5,000 in a nondeductible traditional IRA and $45,000 in a deductible traditional IRA for a total of $50,000.
deductible IRA funds / total traditional IRA funds = $45,000 / $50,000 = 90%
Thus 90% of any amount you decided you convert to a Roth IRA would be subject to income tax. For example, if you converted $20,000 of your traditional IRA savings to a Roth, then you'd pay tax on $18,000 of it ($20,000 x 90%), while the remaining $2,000 would be considered a tax-free return of principal.
It may take a few extra steps, but anyone can enjoy the unique benefits of a Roth IRA of they want to. For more information on Roth conversions, check out IRS Publication 590.
