Roth conversion is a retirement planning strategy that allows you to contribute nondeductible IRA contributions but then convert them immediately into a Roth IRA. It's a great way to avoid required minimum distributions in the future and add tax diversification to your retirement accounts.
But there are some pitfalls to consider before attempting this strategy. First, you must understand the IRS's IRA aggregation and pro-rata rules.
For some investors, a backdoor Roth conversion can effectively work around income limits for a Roth IRA contribution. However, the strategy can also have tax implications and may only be appropriate for some.
A backdoor Roth conversion occurs when you have pretax traditional IRA contributions that you want to convert to a Roth IRA. The conversion will be taxable because of the pro-rata rule, which requires all IRA distributions to be proportionally divided between pretax and after-tax IRA contribution dollars.
If you're considering a backdoor Roth conversion, consult a financial professional. They can help determine if it makes sense for your situation and is worth the added taxes.
A backdoor Roth conversion can be done as a partial or total conversion. A partial conversion involves rolling over a portion of the IRA balance to a Roth IRA, while a complete transformation involves liquidating the traditional IRA and converting the entire account.
A backdoor Roth IRA conversion is a great way to take advantage of the tax benefits of a Roth IRA. However, it may be a good idea to consult with a tax professional before you do it.
The IRS rules associated with IRAs make the process of a backdoor Roth conversion a bit tricky. Specifically, the aggregation and pro rata rules can significantly affect how much money you owe taxes.
The IRS requires that any distributions from your IRAs be taken on a prorated basis between pretax and after-tax money. So if you have a balance of after-tax and pretax money in your IRAs, you could be owed a large amount of taxes when you do a backdoor Roth conversion.
The taxes you pay can be a significant concern, but they usually are relatively inexpensive. And even if you end up paying a substantial amount of taxes, it's unlikely that the overall result will be worse than it would have been if you just left your traditional IRAs alone and paid income tax on them during retirement.
A backdoor Roth conversion can be helpful for high earners who cannot contribute to a Roth IRA because of income limits. But this strategy can be costly, especially if you have a large amount of traditional IRA funds that you are trying to convert.
It's essential to understand the tax implications of a backdoor Roth conversion before making it. It's also a good idea to talk to a financial advisor about whether it makes sense for you.
The backdoor Roth strategy is a popular way for high earners to bypass the earnings limits on Roth IRA contributions. But a bill in Congress to close the loophole is stalled, and it's still being determined whether it will be passed into law.
One significant risk associated with a backdoor Roth conversion is the pro-rata rule, which determines how much of your transformation is considered to come from nondeductible IRA contributions and other pretax IRA assets. If you have large amounts of nondeductible IRA funds and additional traditional IRA assets, the IRS might want a cut of the total conversion amount.
The main risk associated with a backdoor Roth conversion is that the IRS might find it to be an impermissible contribution. This is because the strategy violates a tax rule called the step transaction doctrine, which says that a series of separate steps can be treated as a single transaction for tax purposes.
Specifically, backdoor Roth conversions could be considered a violation of this rule if they are made in rapid succession. This would be analogous to speeding 57 mph in a 55 mph zone; the odds of being caught are relatively low, but if you get pulled over and end up in court, it may be hard to dispute your guilt!
Another risk is that the IRS may decide to close the backdoor Roth loophole in the future. A provision in President Biden's $1.7 trillion omnibus legislation--The Build Back Better Act--would likely do this, but the bill has been held up by Senator Joe Manchin from West Virginia. If this happens, it's possible that backdoor Roth conversions could be banned altogether beginning in 2022.