4 Misconceptions About Backdoor Roth IRA Conversions

I recently did a presentation for a group of 30-something professional women in an investment club. The hot topic of the evening wasn't why their top holding,
 Procter & Gamble (PG), was underperforming the market or whether they should follow Morningstar analysts' recommendations and buy energy stocks.

Rather, they all wanted to know about so-called backdoor Roth IRAs. Should they start them, and what should they know before they do?

Granted, the backdoor Roth IRA is only of interest to a fairly small, rarefied subset of the population--those who earn too much to contribute to a Roth IRA directly. (In 2012, the income limit for Roth contributions is $183,000 if part of a married couple filing jointly, and $125,000 for single filers.) For such individuals, their only method of getting new assets into a Roth IRA is to go in through the backdoor, opening traditional nondeductible IRAs, then converting those accounts to Roths. Whereas income limits curtail higher-income earners' ability to contribute to a Roth outright, anyone can do a conversion, regardless of income.

I've been enthusing about the backdoor Roth IRA since Congress lifted the income limits on conversions starting in 2010 because it's a way for higher-income folks to pay tax now in exchange for tax-free withdrawals of at least some of their assets during retirement. But the maneuver carries some important caveats and could trigger tax costs in certain situations, so it pays to stay attuned to them before opening an account.

Here are four of the biggest misconceptions about backdoor Roth IRAs:

Misconception 1: Backdoor Roth IRAs Are Always Tax-Free
One of the reasons the backdoor concept has taken off is that the maneuver can be nearly tax-free for many people: When you convert the newly opened traditional IRA to a Roth, you'll owe taxes on any appreciation in your shares since you made the initial purchase, but that's it--assuming you have no other IRA assets. But if you do hold other IRA assets, you'll be affected by what's called the pro rata rule. Under that rule, the IRA looks at your whole IRA kitty to determine your tax bill when you do the conversion; the tax you pay depends on your ratio of assets that have already been taxed to those that have not. Say, for example, you have $45,000 in a rollover IRA from a previous employer as well as $5,000 in your new nondeductible IRA. That means your ratio of taxable/tax-free assets in your total IRA is 9/1. Upon conversion of that new $5,000 traditional IRA, you'd owe taxes on $4,500 of income, because 90% of your total IRA pool consists of money that has not been taxed. That tax treatment holds even if you haven't laid a finger on your rollover dollars.

You'll run into the same issue if you try to execute a backdoor IRA and you also have traditional IRA assets on which you've taken a tax deduction; ditto if you have made nondeductible contributions but a big share of your IRA balance consists of appreciation. In both cases, the pro rata rule would affect the taxes due when you converted your new traditional nondeductible IRA to a Roth.

Misconception 2: A Backdoor IRA Should Always Be Off-Limits if You Have Traditional IRA Assets
The preceding example illustrates how ugly the tax treatment can be if you undertake a backdoor IRA and have a lot of money in a traditional or rollover IRA that has never been taxed. However, that doesn't mean you should avoid the maneuver at all costs if you have other IRA assets. If you have a rollover IRA and participate in a decent company retirement plan that permits it, you can roll that money into the 401(k) before executing the backdoor Roth IRA maneuver. In so doing, those dollars wouldn't be part of the calculation of taxes due under the pro rata rule; they'd be effectively removed from the calculation.

Misconception 3: Once You Go Backdoor, You Can Readily Make Additional Roth Contributions in Future Years
One other common misconception about backdoor IRAs is that once you do one, you're automatically in the Roth club, and can make additional Roth contributions without jumping through the same hoops. Ah, would that it were so. Unfortunately, that's true only if your income falls below the Roth IRA eligibility thresholds in future years, or if you no longer participate in a company retirement plan. If that's the case, you can make a Roth contribution outright. All others, however, will have to go through the same motions to make additional Roth contributions, first contributing to a traditional nondeductible IRA and then converting to a Roth thereafter.

At the same time, the fact that you have to execute the same maneuver year after year doesn't mean that you have to open up new accounts, both traditional and Roth, in each calendar year. All of your conversions can spill into the same Roth IRA, and you may even be able to use the same nondeductible IRA each year, as well. Check with your provider about the minimum balance, if any, you'd need to maintain to keep your traditional IRA viable after you've moved the money into your Roth; also ask about any account maintenance fees you could incur with a low balance. 

Misconception 4: All Roth IRAs Give You Easy Access to Your Cash
Flexibility is one of the key benefits to having a Roth IRA: If you make direct contributions (that is, your entry point into a Roth isn't through converting), you can withdraw your contributions at any time and for any reason without owing tax or a penalty. But if you get into a Roth IRA via conversion, you're governed by a different, and stricter, set of rules. Amounts that were taxable at the time of conversion are subject to a 10% penalty if withdrawn before five years have elapsed following the conversion, unless the IRA holder is age 59 1/2, disabled, or meets other exceptions, as laid out in IRS Publication 590. Of course, in many cases backdoor IRA Roth converters will owe little--if any--taxes at the time of conversion, so the penalty wouldn't apply. But if there were taxes due upon conversion--either due to appreciation of the securities in the traditional IRA or the IRA holder had other traditional IRA assets at the time of conversion (see the pro rata rule outlined in Misconception 1)--tapping the Roth before five years have passed could carry a penalty.   

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