Using a “Back Door Roth” IRA? Be Mindful of the IRA Aggregation Rule

As many of you know, the concept of a “back door Roth” IRA is relatively simple. It allows taxpayers with higher incomes ($132,000 or more if you’re single, and $194,000 or more for married couples filing jointly in 2016) to fund their Roth accounts through contributions to traditional IRA accounts and subsequently convert them to a Roth. When the IRS removed income limits on conversions in 2010, anyone with funds in a traditional IRA account became eligible for a Roth conversion.

Planning to use the back door Roth IRA technique? Be mindful of the IRA aggregation rule. In a situation when a taxpayer has more than one IRA account, the rule requires that for purposes of computing the taxable amount of any distribution, all of the IRA accounts will be considered as one combined account. Effectively upon conversion, only a pro-rata portion of non-deductible contributions will be converted tax-free even though a separate account has been established for the conversion. Let’s look at the following example:

Facts: Taxpayer (assuming under age 50) has $100,000 in an existing IRA account; opens a separate traditional IRA account and contributes $5,500 with intent to convert that amount to a Roth account.

Result: Only $286.55 ($5,500/$105,500=5.21%) of the $5,500 after-tax contributions will be converted on a pro-rata basis and the difference of $5,213.45 will be treated as a taxable distribution. Therefore, after the conversion, the taxpayer will end up with $5,500 in a Roth IRA account and $100,000 in a traditional IRA with a tax basis of $5,213.45.

Please note the aggregation rule applies on an individual taxpayer basis; meaning that for the married couple, the husband’s and wife’s IRA accounts are not aggregated together. Also, any employer-sponsored retirement plan such as a 401(k) is not aggregated; however, SEP IRA accounts commonly used by self-employed individuals are aggregated.

The resolution for many taxpayers could be rolling IRA funds into an existing 401(k) plan as long as the employer’s plan allows for such roll-in contributions. Similarly, for self-employed taxpayers, a solo 401(k) can be set up and IRA/SEP IRA funds subsequently rolled over to that plan. Both of these options will help taxpayers effectively avoid the IRA aggregation rule and effectively perform the back door Roth IRA conversion strategy.

Contact Aprio’s Wealth Management team to learn more about the back door Roth IRA strategy and evaluate whether it’s right for you.