Non-Deductible IRA to Roth IRA Conversion: Beware of the Aggregation Rule
November 14, 2019 | Stanley K. Himeno-Okamoto, CFP®, CFA
High-earners who are ineligible to directly contribute to a Roth IRA or make pre-tax Traditional IRA contributions (usually due to income restrictions) often consider funding non-deductible IRAs to maximize the amount of money in tax-advantaged accounts. Non-deductible IRAs are like a hybrid between Traditional IRAs and Roth IRAs – contributions are made on an after-tax basis and are not taxed at withdrawal (like Roth accounts), while earnings are tax-deferred until withdrawal (like Traditional IRAs).
Roth IRAs enjoy tax-free earnings in retirement, giving them an edge over the deferred taxation of earnings for non-deductible IRAs. This is where the Roth conversion comes in. Since both non-deductible and Roth IRA contributions are made with after-tax income, a Roth conversion will incur no additional taxes if the conversion is done correctly, effectively turning your non-deductible IRA contribution into a Roth IRA and skirting the contribution limitations for Roth IRAs, hence the “Backdoor Roth” nickname.
It’s a simple strategy, right? Contribute $6,000 (the 2019 contribution limit for people under the age of 50) annually to a non-deductible IRA, and immediately perform a Roth conversion. Aside from income tax on the $6,000 you would have incurred no matter what (remember, we’re talking about non-deductible IRAs specifically), no future capital gains or income taxes.
If it sounds too good to be true, you’re partially right. There’s a catch (but a way to avoid it too). Buried in the US Tax Code, the aggregation rule states that all IRA accounts are treated as one combined account for tax considerations, and distributions or conversions are taxed on a pro-rata basis. As an example, if you have a $90,000 pre-tax Rollover IRA and $10,000 in non-deductible contributions, even if they are in separate IRAs, 90% of any Roth conversion is taxable, regardless of which account the conversion funds actually came from. For someone trying to create a “Backdoor Roth” with non-deductible contributions, this can result in a nasty surprise come tax season if the aggregation rule wasn’t taken into account.
To avoid the tax hit from the aggregation rule, you have to ensure your IRAs have no pre-tax contributions or earnings. Some 401(k) plans will let you roll your Rollover and/or Traditional IRAs into your active 401(k) account, removing your pre-tax IRA contributions and earnings from the aggregated IRA “bucket” and leaving only your non-deductible contributions behind.
The aggregation rule makes what at first appears to be a simple strategy far more complex, and you might think it wouldn’t be worth the effort just to convert $6,000 a year, but consider the effects over time. At an annualized 7.2%, your $6,000 doubles in 10 years, doubling again after another 10 years, and so on. Considering the fact that gains in a ROTH account aren't taxed at withdrawal, and you can see how the benefit from tax savings can be huge. This is just one aspect of someone’s overall financial picture, and should be evaluated in coordination with everything else to implement a sturdy but flexible financial plan.
If you're considering ROTH conversions to gain an edge with your retirement planning or are looking for help getting on the right track for retirement, send us an email or schedule a time to talk to a ClearPath financial planner.
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