Backdoor Roth IRAs Could Cost Some Investors at Tax Time

You may have seen several mentions of the so-called backdoor IRA during the past year and a half. Despite its illicit-sounding name, this maneuver is perfectly legal and it can help you diversify your retirement portfolio's tax treatment.

However, if you have other IRA assets that haven't been taxed yet, you need to think twice before engineering a backdoor Roth. If you don't, your new Roth IRA could cost you a lot more in taxes than you had planned.

The Maneuver
Before getting into how a backdoor Roth can be costly from a tax standpoint, let's first discuss how this move, when properly executed, works and how it can be beneficial for savers in certain instances.

First, it's worth noting that a backdoor Roth is only appropriate for those who earn too much to contribute to a Roth the conventional way: For 2010, the maximum adjusted gross income cutoff for married couples filing jointly is $177,000 and the income limit caps out at $120,000 for single filers. If your household's income is below those thresholds, you can get into a Roth through the front door.

But assuming that your income is higher than that, you can take advantage of the fact that beginning in 2010, there are no longer any income limits on who can convert a traditional IRA to a Roth. Don't ask me why Congress has left open this gaping loophole, because it doesn't lead directly to new tax revenues, but for now it provides a way for higher-end investors to get new assets into a Roth.

Say, for example, a 55-year-old with an adjusted gross income of $185,000 and no other traditional IRA assets puts $6,000 into a traditional nondeductible IRA. (The "nondeductible" piece means that his contribution consists of money that has already been taxed; he can't deduct his contribution on his tax return because he earns too much.) He could then immediately convert that IRA to a Roth, thereby ensuring tax-free withdrawals on that money in retirement.

Normally, the big hitch with an IRA conversion is that converters owe taxes on the part of their IRAs that haven't been taxed yet such as any deductible contributions or investment earnings, including money rolled over from a traditional 401(k). But assuming the backdoor converter doesn't see the value of his IRA shoot up between the time he opens his account and the time he converts, his tax bill on the conversion would be minimal or even zero. That's because he already paid taxes on his contribution, and he'll have limited to no investment gains on which he'll owe taxes at that point. In addition to avoiding taxes on the conversion, he'll also have gotten some of his retirement assets into the tax-free withdrawal column, which is beneficial for people like him who have, up until now, earned too much to contribute to a Roth IRA.

The Maneuver Gone Awry
Remember, however, that the above example hinged on the fact that the backdoor IRA converter had no other traditional IRA assets. But let's take a look at another example--one with other IRA assets in the mix--to illustrate how setting up a backdoor IRA can spell extra taxes.

Let's assume a 32-year-old woman who earns $200,000 a year and has $20,000 in traditional IRA assets puts $5,000 into a traditional nondeductible IRA, seeking to take advantage of the backdoor conversion option. At first blush, it seems like this converter shouldn't owe any taxes, either. Her contribution to the new IRA, as in the previous example, was already taxed, and if she makes the conversion right away, before her investment goes up in value, she wouldn't owe any taxes on investment gains, either.

But here's where the tax pain comes in. Her other traditional IRA assets consist entirely of money that she had rolled over from an old 401(k) plan, meaning that money has never been taxed. (With traditional 401(k)s, you're not taxed upon your initial contribution and you're not taxed on your investment gains until you begin taking money out.)

Because of those other IRA assets, the tax she'll owe upon conversion will depend on percentage of taxable versus tax-free assets in all of her IRA accounts, not just the one she just opened.

In her case, $20,000 of her IRA assets haven't yet been taxed totals and her new nondeductible IRA contribution of $5,000 already has. That means that 80%, or $4,000, of her recent $5,000 contribution would be taxable upon conversion; only $1,000 (the other 20%) would not be.

All of this means that if you have other traditional IRA assets, or SEP and SIMPLE IRAs, you'll need to proceed carefully before opening up a traditional nondeductible IRA with an eye toward immediately converting to a Roth. This maneuver can work beautifully for those with no other IRA assets, but it can be a tax headache with those who do. Check with a tax advisor before proceeding. You may also be able to conduct a series of partial conversions over a period of time, thereby limiting the tax hit in any one year.

It's also worth noting that you have an escape hatch if you would like to do a backdoor IRA but have other IRA assets that you've rolled over from a previous employer's 401(k). Assuming your new employer also has a 401(k) plan that allows you to do so, you could roll the IRA assets into that plan, thereby reducing or eliminating the taxes owed upon conversion of a new backdoor Roth. Of course, the merits of this strategy will depend entirely on the quality and fees associated with the new plan.

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