A. Backdoor Roths can make sense under the right circumstances.
The Backdoor Roth is used by taxpayers who, due to income limitations specific to their federal tax filing status, cannot contribute to a Roth IRA. When the front door is locked, go through the back door! (FYI: If your 401(k) plan allows for Roth contributions, the income limitations do not apply.)
In a perfect world, the taxpayer makes a non-deductible contribution to a traditional IRA–which is always permitted when income exceeds the Roth IRA threshold–and then affects a Roth conversion. (Conversions are also always permitted regardless of income.) The account balance is withdrawn and deposited into a Roth IRA. A Roth conversion is potentially a taxable event. After-tax contributions are converted to the Roth without tax consequences. Assuming very little interest or gain has been earned on the non-deductible contribution given the speed at which it was undertaken, there is little or no income tax to pay for the conversion and the contribution ends up in the Roth IRA through the backdoor.
Works pretty slick, huh? At least in a perfect world.
Here’s a possible “monkey wrench” of the strategy: If the taxpayer has other IRAs, the pro-rata rule applies and a calculation is required involving the total of all IRAs. Its purpose is to determine how much of the dollar amount being converted to a Roth will be tax-free. Let’s look at an example.
Mary has three non-Roth IRAs totaling $47,000 into which she had in prior years made both deductible and non-deductible contributions, the latter totaling $7,000. Because of income constraints, Mary must resort to a Backdoor Roth to get money into a Roth account. She opens a fourth IRA and deposits $3,000 with the intent of converting that $3,000 to a Roth IRA. She now has $50,000 in total IRA value of which $10,000 is her non-deductible contributions—or 20% of her total IRAs ($10,000 divided by $50,000 is 20%).
Mary can convert the most recent $3,000 contribution to a Roth, but because of the pro-rate rule only $600 of that amount ($3,000 times 20% equals $600) will be considered a return of her pre-tax money, and the $2,400 remainder will be taxable income.
Regardless of which of her four IRA accounts she would make a withdrawal from for the Roth conversion, the taxable amount is the same. If within all your IRAs, there are tax-deferred amounts, the IRS does not allow you to convert only your tax-deductible contributions.
If a Backdoor Roth or a plain-vanilla Roth conversion results in taxable income, that’s not necessarily a deal killer. The conversion still might make sense under the right circumstances.
(FYI: the IRS applies the pro-rata rule to your total IRA balance at year-end, not at the time of conversion. Consult a CPA or use worksheets the IRA makes available on its website to help you make a Roth conversion properly.)