The Back-door ROTH IRA
Typically, taxpayers can only contribute to a Roth IRA if they have taxable compensation and income less than the top of the phaseout range for their filing status (see chart below). If your income is greater than that threshold amount, you are prohibited from contributing directly to a Roth IRA. A "back-door" ROTH IRA allows a taxpayer to bypass income limitations by first making a nondeductible contribution to a traditional IRA and then converting it into a Roth IRA. If the conversion happens soon after the original contribution, there may be little or no taxable income or tax assessed. Due to the distribution rules for traditional IRAs, this works best if you have no other
traditional IRAs (as explained later under the AGGREGATION RULE).
Generally, if you are prohibited from making a direct Roth IRA contribution, you are phased out from making a deductible traditional IRA contribution as well. Therefore, in order to make a back-door Roth IRA contribution, you would first make a nondeductible contribution to a traditional IRA. Nondeductible contributions are considered to be made with money you have already paid tax on, or “after tax.” Shortly after making a nondeductible contribution to a traditional IRA, you can convert
the traditional IRA to a Roth IRA.
You can withdraw all or part of the assets from a traditional IRA and reinvest them in a Roth IRA. The amount that you withdraw and timely contribute (convert) to the Roth IRA is called a conversion contribution. If properly rolled over, the 10% additional tax on early distributions will not apply. However, a part or all of the distribution from your traditional IRA may be included in gross income and subject to ordinary income tax. There are no income limitations on converting a traditional IRA into a Roth IRA. The conversion is treated as a rollover, regardless of the conversion method used.
Conversion of deductible IRA. If you convert a traditional IRA that you received a tax deduction on in a previous year to a Roth IRA, you will owe taxes on the entire amount converted.
Example: Luca has a traditional IRA with a fair market value of $500,000. All of the contributions to the traditional IRA were deductible. If Luca converts the entire $500,000 traditional IRA to a Roth IRA, she will owe ordinary income taxes on the full $500,000 amount.
Conversion of nondeductible IRA. If you make a nondeductible contribution to a traditional IRA, you can convert the entire amount tax-free. Only the earnings on the non-deductible IRA contributions are taxed.
Example: Marco is single and has a modified AGI of $250,000. He wishes to save money in a Roth IRA so he can make nontaxable withdrawals upon retirement. In 2022, he opens a traditional IRA with a $6,000 nondeductible contribution and a couple months later, converts it to a Roth IRA. He has no other traditional IRAs. At the time of Roth conversion, the account had increased in value by $250, which is the only taxable part of the conversion.
Conversion of part-deductible/nondeductible IRA. If you make a conversion to a Roth IRA that consists of de-ductible and nondeductible IRA contributions, you will owe tax on the proportion of your overall IRA balance that is considered after tax (nondeductible) as compared to be-fore tax (deductible). You cannot choose to have the cost basis distributed first. Additionally, the values of all
traditional IRAs are aggregated to determine the taxable portion of a distribution. Each distribution is partly nontaxable and partly taxable until your entire cost basis has been distributed.
Note: Because of these traditional IRA distribution rules, the back-door Roth IRA works best if you do not have any other traditional IRAs.
The AGGREGATION RULE
Example: Alessandra has $94,000 in her traditional IRA, all of which is pre-tax. If Alessandra makes a $6,000 nondeductible (after-tax) contribution to a traditional IRA, her total IRA balance will be $100,000, $6,000 of which will be after-tax. Thus, only 6% ($6,000 ÷ $100,000 = 6%) of her Roth IRA conversion will be tax-free. If Alessandra converts $6,000 from her traditional IRA to a Roth IRA after making her nondeductible contribution, just $360 would be tax free ($6,000 × 6%), while the remaining $5,640 ($6,000 – $360 = $5,640) would be taxable.
A potential workaround to the Aggregation Rule (Pro-rata Rule): If you are currently participating in an employer sponsored retirement plan 401(k), the aggregation rule could be avoided (using the example above) by rolling the $94,000 Traditional IRA into the taxpayer’s employer sponsored retirement plan. This would then leave a zero balance in the taxpayer's traditional IRA account.
This material contains general information for taxpayers and should not be relied upon as the only source of authority. Taxpayers should seek professional tax advice for more information. Amoretti Advisors & Intent Investment Management, assume no responsibility for any individual’s
reliance on the information disseminated unless, of course, that reliance is as a result of the firms' specific recommendation made to a client as part of our representation of the client. Please note that changes in the law occur and that information contained herein may need to be reverified
from time to time to ensure it is still current. This information was last updated in September, 2022.
Source: IRS, Publication 519-A