Understanding the Rules for IRA Conversions

by NerdWallet | July 16, 2013 10:05 am

Understanding the Rules for IRA Conversions

Hi Joanna,

From what I gathered after reviewing the backdoor Roth IRA option, you can make non deductible IRA contribution and convert to a Roth.  However, it is pro rata based on what amount of deductible IRA monies I already had in the IRA account, relative to non deductible, correct?

Can a workaround to this strategy be to open a new Traditional IRA, say at Fidelity Investments for no fee or no cost to open, fund $5,500 (or $6,500 catch up) directly into the IRA as a non deductible contribution into, say, cash reserves with no growth to that investment.  Then, immediately convert into an existing Roth IRA account. That way, no growth (i.e., tax on earnings) AND no pro-rata basis from Traditional IRA (being that it is a new IRA account with no deductible contributions in existence) and that constitutes full accordance with IRS mandate? End goal being tax-free growth on Roth IRA and ability to avoid any MAGI issues with income restrictions and contributions? Each year, technically, you could do this using a “shell” IRA account with absolutely no deductible monies in that account prior, correct?

Any thoughts or confirmation of this example would be greatly appreciated.

Thank you in advance!

-Thomas H.

Hi Thomas,

You don’t say whether or not you have existing deductible Traditional IRA assets.  If you don’t, then your plan is a very clean way of executing the Backdoor Roth IRA[1] for high income earners.

But I suspect you are asking this because you do have existing pre-tax assets and are looking for a way to make a non-deductible contribution and convert it to Roth without having to convert all of your existing deductible assets as well.  Unfortunately, the IRS pro-rata rule applies to all money across ALL accounts, so you can’t get around it by opening a new separate account at a different company.

For example, if you have $45,000 of deductible assets in a Traditional IRA with Vanguard and open a new Traditional IRA with Fidelity and fund it with $5,000 of non-deductible assets, you cannot then rollover $5,000 and claim you were rolling over only the non-deductible portion.  The government will treat your $5,000 rollover as a 10% rollover ($5,000 is 10% of your total Traditional IRA assets) and will treat $4,500 of your Vanguard $45,000 as rolled over and $500 of your $5,000 Fidelity account as rolled over, which doesn’t accomplish your goal of converting non-deductible assets into a Roth.

So those with existing pre-tax assets basically have 3 options:

  1. Convert all Traditional assets and pay income taxes on the pre-tax amount converted - Your present tax bill could be substantial, but this will allow you to contribute to a Backdoor IRA in the current and any future years, using the method you outline above.  This is an especially good option for those with a relatively long time until retirement since they will have many years to reap the benefits of additional tax-advantaged contributions.
  2. Keep your pre-tax assets and contribute to a non-deductible Traditional IRA - If you have too many pre-tax assets and cannot afford the tax bill from converting, it can make sense to contribute to a non-deductible Traditional IRA.  While this does not provide the flexibility of a taxable account or the full tax benefit of a deductible account, there are still slight tax benefits from deferrment of taxes on investment gains.  Plus, you may be able to afford to convert your accounts little by little, so your non-deductible contributions could eventually become post-tax Roth contributions.
  3. Do nothing – Some people like to have Traditional (pre-tax) assets over Roth (post-tax) assets or a mix of the two because of their view on the future direction of tax rates.  My personal preference is to get as much money as possible into any tax-advantaged account[2] I can because of the huge benefits on tax-advantaged compounding over time, but other people feel strongly that diversification of tax rate exposure is equally important and that’s a legitimate point of view.  So if you have a lot of Traditional assets that you don’t want to convert for this reason and you prefer taxable accounts to non-deductive Traditional IRAs (which account type is superior is very dependent on investment assumptions), then you would be justified in doing nothing.

Related Content

NerdWallet’s recommended IRA account providers[3]

Is it better to contribute to a Roth or Traditional IRA?[4]

 I’m only 22.  Should I contribute to my company’s 401k?[5]

Written for NerdWallet by Joanna D. Pratt, a CFA (Chartered Financial Analyst), an experienced institutional investor.  She holds a bachelor’s degree in economics and certificate in finance from Princeton and an MBA from Stanford.

Endnotes:
  1. Backdoor Roth IRA: http://www.nerdwallet.com/blog/investing/2013/backdoor-roth-ira-high-income-how-to-guide/
  2. get as much money as possible into any tax-advantaged account: http://www.nerdwallet.com/blog/investing/2013/roth-traditional-ira-401k/
  3. NerdWallet’s recommended IRA account providers: http://www.nerdwallet.com/blog/investing/2013/roth-ira-account-provider-2013/
  4. Is it better to contribute to a Roth or Traditional IRA?: http://www.nerdwallet.com/blog/investing/2013/roth-traditional-ira-401k/
  5.  I’m only 22.  Should I contribute to my company’s 401k?: http://www.nerdwallet.com/blog/investing/2012/contribute-company-401k/

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