How to Fund a Backdoor Roth IRA

Christine Benz: Ed, I want to talk about what we have been calling a backdoor IRA, Roth IRA. So, the idea is that if you had earned too much to contribute directly to a Roth, you would open a traditional nondeductable IRA and then convert at some point down the line. What's your take on that maneuver, good or bad?

Ed Slott: That's a great maneuver, I advise it all the time. It's a quirk in the tax law, it's almost an unintended consequence or an oversight because of conversions now, and since 2010, anyone can convert. All the income limits were removed. So you can have for unlimited amount. Somebody if they have the money could convert $10 million because all the income limits were removed, but yet for $5,000 Roth contribution the government says no, there we are going to draw the line. $10 million is fine but for the $5,000 we have limit, and I think they just forgot to get rid of them or it's a nutty thing.

So, it's an easy work-around. You contribute to a traditional non-deductible IRA as long as you have earnings and then convert it to a Roth, since anybody can convert. There is one caveat though, not everybody can contribute to a traditional non-deductable IRA. First, you have to have earnings, and with traditional IRAs you can't contribute after you are 70 1/2. You can with a Roth but you can't with a traditional. So, if you are listening to this and you are 75, that tactic won't work for you.

Benz: So, what happens if I have other traditional IRA assets? Is there a potential tax trigger for me there if I do this backdoor conversion, that's maybe not such a good idea?

Slott: What happens is, if you do a nondeductable, you have to do what's called, it's a little technical, a pro rata calculation. In other words, you can't just, and this is a question we get a lot so I am glad you asked, some people say well if I do a non-deductable IRA say for $5,000, can I just convert the $5,000 and pay no tax? Not if you have other IRAs because all of your IRAs by tax rules are considered one. So, if $5,000 was only 5% of your whole IRA, only 5% would be tax-free. You have to do a percentage for every dollar you convert.