A New Twist On Roth IRA Conversions

Jun. 17, 2018 11:21 AM ET

By Matt Sommer

In a new series, retirement and wealth strategies expert Matt Sommer answers questions from advisors on market events, legislation and trends that may impact their clients' investments.

What is the difference between a "backdoor Roth IRA" and a "mega Roth" and how can my clients utilize them?

Both the backdoor Roth and mega Roth strategies may offer higher-income investors the opportunity to fund a Roth who might otherwise not be eligible. Let's take the backdoor Roth first, as it is likely more familiar to readers. In 2018, only taxpayers with adjusted gross income less than $120,000 (single) and $189,000 (married filing jointly) may fully contribute to a Roth IRA, provided they or their spouses have earned income. One clever way around these income limitations is to fund a non-deductible IRA, then immediately convert the non-deductible IRA to a Roth IRA. Unlike Roth contributions, Roth conversions are not limited by income and since the converted amount consists only of a taxpayer's basis (non-deductible, after-tax contributions) there are no resulting tax implications. The final result is a $5,500 contribution (or $6,500 if age 50 or older) to a Roth, regardless of a taxpayer's income.

So, what is the catch and why don't more taxpayers take advantage of this loophole? The answer lies in what is commonly referred to as the pro-rata rule. When a taxpayer takes a distribution from an IRA, a pro-rata portion of the distribution is considered pre-tax, assuming the taxpayer's IRAs contain any after-tax dollars. For example, suppose a taxpayer has a $300,000 IRA rollover and attempts to do a backdoor Roth. Using the pro-rata rule, approximately 2% of the $5,500 conversion would be non-taxable, and 98% would be taxable. In short, all of a taxpayer's IRAs must be considered under the pro-rata rule, making the backdoor Roth difficult for investors with existing rollovers and other substantial pre-tax IRAs.

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