Backdoor Roth IRA Pitfall #3: Unintended Costs “If you think there’s any chance you may need the money sooner than five years, you might want to reconsider making the move,” says says Brian Robinson, a certified financial planner ( CFP) in Phoenix. (Your untaxed earnings will be subject to taxes regardless, unless you’re over 59 ½ and it’s been at least five years since you first contributed to a Roth account.) Each of your converted Roth IRAs has its own five-year clock on it that’s subject to the 10% penalty if you make a withdrawal before five years is up but while you’re still under 59 ½. There’s an additional wrinkle with this rule when you do backdoor conversions, though. If you withdraw funds before five years are up, you may owe taxes and a 10% penalty on the withdrawal, if you’re under 59 ½. The five-year clock starts ticking on January 1 of the year you made your first contribution. There’s just one limit on this feature: You have to wait five years after making your first contribution to avoid taxes when taking withdrawals from the account. One of the big benefits of the Roth IRA is that you can withdraw your contributions from the account at any time, for any reason, without incurring penalties or taxes. Backdoor Roth IRA Pitfall #2: The 5-Year Rule You owe income tax on the other $5,640 you backdoored. That means only $360 of your $6,000 backdoor conversion is tax-free (6% of $6,000). And now you contribute $6,000 to a new traditional IRA with after-tax dollars, then immediately convert that $6,000 to a Roth via the backdoor Roth IRA strategy.Īs far as the IRS is concerned, you now have $100,000 in traditional IRAs, and the $6,000 you are contributing with after-tax dollars represents 6% of your total. Whatever that percentage is determines the percentage of your backdoor Roth IRA conversion that will be taxed.įor example, let’s say you have $94,000 in existing traditional IRAs that were funded with pre-tax dollars. The pro-rata rule boils down to the percentage of your total combined IRA balances that has yet to be taxed. The Pro-Rata Rule and Backdoor Roth Conversionsįor tax purposes, the IRS considers all your (seemingly separate) IRAs as one big account. Here’s the big honking catch, though: If you have pre-tax money sitting in any other traditional IRA accounts, your backdoor Roth conversion will trigger a tax bill, courtesy of the IRS’ pro-rata rule. Practically speaking, you can avoid this as long as you don’t invest the money when you put it into your IRA and then you convert it to a Roth quickly. And when you convert a traditional IRA to a Roth IRA, you owe a bill to Uncle Sam on any money that hasn’t been taxed yet.
Two facts to keep in mind: Non-deductible contributions are made with money that’s already been taxed.
But if you don’t take into account all of your existing IRAs, you might end up with an unexpected tax bill. The allure of the backdoor Roth IRA is the potential to complete the transaction and avoid any additional taxes you’d face in retirement if you put the money in a traditional IRA. Backdoor Roth IRA Pitfall #1: An Unexpected Tax Bill
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