The Roth IRA presents a great opportunity to put money away for retirement and withdraw it all, free of tax. However, the ability to make such contributions is determinate on income. Many taxpayers find themselves unable to contribute to a Roth because their incomes are too high. As a result, such taxpayers are limited to contributing to a traditional, nondeductible IRA, which is far less tax-favorable than the Roth.
To address this, various articles have appeared describing what is called a “back door” Roth contribution – basically advising taxpayers to contribute to a traditional nondeductible IRA and then roll this contribution into a Roth, all tax-free. While the first part of this statement is true (you can contribute to a nondeductible IRA and then roll that into a Roth), the second part is often not true, resulting in a very nasty tax bite.
As an example, from 2004 thru 2013 a taxpayer contributed $5,000 per year to a nondeductible IRA. That IRA, along with other regular IRA accounts is now worth $1,000,000 and their basis in it is $50,000 (10 years’ worth of nondeductible contributions at $5,000 each). They decide to convert the current year’s $5,000 contribution to the Roth.
Many of the articles out there would lead you to believe, or even state directly, that the $5,000 conversion is tax-free. This is not the case at all. In fact, $4,750 of this conversion is taxable.
The crucial yet omitted information is that you cannot designate which dollars get converted. Saying “I’m just converting the portion that is basis” does not work. Every dollar in an IRA consists partly of basis and partly (in many cases, mostly) of tax-deferred growth. Therefore, if you have a fairly hefty IRA account, odds are that the majority of what you convert will be taxable.
Aronson LLC has represented countless clients in various tax controversy matters and we see this come up all too often because well-meaning articles do not tell the whole story. There is a way to structure this so that the conversion does end up being tax-free, but simply contributing to a traditional IRA and converting to a Roth is going to result in an unpleasant tax surprise.