Example 1:
Lloyd is a high wage earner. He is a single filer, and his MAGI for 2021 will exceed $139,000. He would like to contribute to a Roth IRA. He has no other IRA accounts. He makes a $6,000 contribution to a nondeductible IRA. After several months the value of the account is $6,250. He then converts the whole $6,250. When he files his taxes for 202, he will report the nondeductible traditional IRA on Form 8606 as well as the conversion. Because he has properly reported his after-tax contribution, he will only be liable for tax on the $250 gain.
Example 2:
Same facts as above, but Lloyd does have two other pre-tax IRA accounts. IRA A contains $63,000. IRA B contains $30,750. Lloyd makes his contribution to a new IRA, IRA C, hoping he can isolate the nondeductible contribution and only convert it. He now has IRA C with a balance of $6,000. Lloyd converts IRA C. At the time of the conversion, IRA C has a value of $6,250. He correctly reports the after-tax contribution on Form 8606. He tries to claim that he only owes tax on the $250 worth of growth in IRA C.
The IRS does not agree. They apply the aggregation and pro-rata rules and find that of the amount Lloyd converted only $375 is after-tax making the remaining $5,860 of the conversion taxable. At the time of Lloyd’s conversion, his IRA accounts totaled $100,000. He had an after-tax contribution of $6,000. The pro-rata rule calculation is as follows: $6,000/$100,000 = .06, or 6 percent. To determine the basis included in the conversion, we take that percentage and multiply it by the converted amount .06 x 6,250 = 375. Of the $6,250 Lloyd converted, only $375 is considered to have come from his after-tax contribution. The remaining $5,875 is taxable.
Is there anything Lloyd could have done to avoid the result in Example 2?
Possibly, if Lloyd had an employer plan that accepted rollovers. By rule, a taxpayer may only roll pre-tax IRA money into an employer plan. Any rollover from an IRA to an employer plan drains the pre-tax money first. Rolling all the pre-tax IRA money into a plan, such as a 401k or 403b, would work to isolate the remaining after-tax funds in the IRA. If only the after-tax money is left in the IRA, a Roth conversion of those funds would not generate a taxable result.
When is the pro-rata determination made about IRA accounts? IRC Section 408(d)(2)(C) says that the pro-rata and aggregation rules are applied based on the account values at the end of the taxable year in which a distribution or conversion is made.
Conclusion
The backdoor Roth strategy can be a powerful tool for high-income wage earners, but the strategy can lead to unexpected results if the taxpayer is not aware of all the rules.