People who are otherwise precluded from making direct Roth IRA contributions may consider the two-step back-door Roth IRA. As usual, the devil is in the details.
The “cream in the coffee” rule applies to back-door Roth IRA’s.
That means, if you hold assets in a traditional IRA and you make a nondeductible contribution to your traditional IRA, and then make a distribution from your traditional IRA to your Roth IRA, only a percentage of the distribution from the IRA to the Roth IRA will be tax-free.
If you have more than one IRA, all IRA distributions are treated as one distribution.
The nondeductible amount (that you wanted to put into the Roth IRA) gets blended in with the pre-tax IRA amounts. When you try to extract just the nondeductible amount for inclusion in your Roth IRA, you also extract pre-tax amounts.
The amount that would be treated as tax-free (and not reported as gross income) would be calculated as follows:
Total distribution from IRA’s x (basis in nondeductible IRA assets / total IRA assets) = Tax-free distribution to Roth IRA.
The amount to be reported as taxable from the distribution would be the Total Distribution minus the amount of the tax-fee distribution.
A taxpayer’s basis in an IRA is the nondeductible amount contributed (the after-tax amount). All other amounts in the IRA are tax-deferred.
Example: Jess has $100,000 total IRA assets of which $5000 are nondeductible contributions. Jess decides to make a distribution to fund a Roth IRA. The taxable amount would be:
$5,000 – ((5,000/100,000) X 5,000) = $4,750.
The tax-free amount would be $250. ($5000 distribution - $4,750 taxable amount)
This means the benefits of a back-door Roth IRA might not be as cost effective or as easily attainable as you might have thought if you have traditional IRA assets.
Situations where a back-door Roth IRA would work well
If you have most or all your retirement assets in an employer plan (e.g. 401(k)), then a back-door Roth can work well. The employer plan assets are not factored into the calculation to determine the taxability of a conversion from an IRA to a Roth IRA.
Nonworking spouses who don’t have any IRA assets but can make nondeductible IRA contributions based on their spouses earned income can tax-efficiently utilize the back-door Roth strategy
Good advice: Consult your tax advisor before making decisions abotut your Backdoor IRA because they have tax ramifications.