The Backdoor Roth IRA Conversion Trap That Many Investors Don't Know About
The IRS rule in question that often catches investors off guard is the "pro rata rule" for Roth conversions. Here's how it works:
If you have any existing pre-tax IRA assets when you do a backdoor Roth IRA conversion, the IRS effectively treats it as two transactions:
1. A distribution of your existing pre-tax IRA money
2. A conversion of that pre-tax money to Roth
The end result is you owe ordinary income tax on whatever portion of your existing IRA assets were converted as part of the transaction.
For example, say you have $100,000 in a traditional IRA already and you want to do a backdoor Roth conversion of your newly contributed $6,000 for the year. The $6,000 will be considered its own conversion transaction. But the IRS will also treat it as if you converted 1/17th of your existing $100,000 IRA to Roth as well. If your marginal tax rate is 30%, you would owe 30% x $6,000, or $1,800 in taxes you were not expecting!
As you can see, being unaware of the pro rata rule for backdoor Roth IRA conversions can lead to some very unpleasant tax bills. It essentially eliminates most or all of the tax advantage you were hoping to gain. Investors looking to utilize this technique should first rollover existing IRA assets to their 401(k) plan in order to avoid the pro rata rule and any unintended extra taxes. Doing a little extra planning is well worth keeping more of your hard earned money!
- Created on .