BACK DOOR ROTH CONVERSION GONE WRONG

Portrait of an upset businessman at desk in office. Businessman being depressed by working in office. Young stressed business man feeling strain in eyes after working for long hours on computer.

There are many different accounts available to save money for retirement : 401k, Traditional IRA, Roth IRA, Custodial IRA, SEP IRA, SIMPLE IRA and more. It is important to consult with a qualified professional to know which one is right for you. They all have different eligibility and taxation rules. One size does not fit all.

This article will focus on the  conversion of funds from a Traditional IRA into a Roth IRA. This transaction is more commonly called a “Roth Conversion”. It can be beneficial in the right circumstances but can also cause alot of problems if not done correctly.

Here is the information we need for this example:

ira matrix Source: IRS.gov

There are income limits that eliminate your ability to contribute to a Roth IRA. If you make too much money, you cant contribute to a Roth. Lets keep it as simple as that. There is however, no income limit that impacts your ability to convert funds from a Traditional IRA into a Roth IRA.

If you have taxable compensation, you can contribute to a Traditional IRA. Whether or not that contribution is deductible depends on your income and if you are covered by a 401k plan.

Further, a ” Back Door Roth IRA” is when you make a non deductible contribution to a Traditional IRA and then immediately convert it to a Roth IRA. It is a way for high income earners to create a tax free source of funds for retirement.

Here’s the situation:

Jim and Kim want to have a tax free source of funds to pull from in retirement. They have already taken advantage of their 401k plans at work and have substantial Traditional IRA’s, totaling around $500,000.

Earlier in the week, Jim had an exterminator out to the house to handle an ongoing stink bug problem. The exterminator told Jim that he would most certainly be able to do a “Back Door Roth“. He could make a contribution to a Traditional IRA, which he would not be able to deduct, but could immediately convert it to a Roth tax free!!!

Hot Damn, Honey”, Jim says to Kim. “We can start a tax free Roth IRA” Off they go to open the account and make the conversion.

roth conversion error 3

 

Here is what the exterminator didn’t know and Jim and Kim didn’t look into.

When determining the taxable portion of the Roth Conversion, you must consider ALL of your Traditional IRA assets. So….

$500,000 + $11,000 = $511,000 in total IRA Assets

Conversion to Roth of $11,000

$11,000/$511,000 = 2.1% (the portion that is tax free)

$11,000 * 97.9% = $10,769 of taxable income.

 

“Well”, Jim says to Kim, “at least we learned something from all this”, as a stinkbug falls into his Iced Tea!

DISCLOSURE: THIS POST IN WRRITEN FOR INFORMATIONAL PURPOSES ONLY AND CONTAINS MATERIAL FROM SOURCES BELIEVED TO BE RELIABLE. IT IS NOT INTENDED AS INVESTMENT ADVICE AND SHOULD NOT BE RELIED UPON AS SUCH. CONSULT A QUALIFIED FINANCIAL ADVISOR OR TAX ADVISOR TO DETERMINE WHAT INVESTMETNS ARE APPROPRIATE FOR YOU AND YOUR INDIVIDUAL SITUATION.