Many are familiar with the backdoor Roth conversion strategy. In this strategy you contribute to your traditional IRA without taking the deduction (a nondeductible contribution) and then later convert that contribution to Roth (a Roth conversion) to fund your Roth IRA even though your Modified Adjusted Gross Income (MAGI) is too high to contribute directly. The idea is that the bouncer at the front door won’t let you contribute, but you are sneaking money into your Roth IRA via the backdoor.
Alas, having any assets in another pre-tax IRA prevents the backdoor Roth strategy from working to its full effect. If you distribute or convert from an IRA while you have a nondeductible basis, you are required to calculate which part of the distribution is traditional (deductible) and which part is nondeductible by prorating your distribution as though all of your IRAs are mixed together.
This means that even though you contributed $6,000 in nondeductible IRA contributions and converted those very same $6,000 in Roth conversion, the Roth conversion will be prorated into its separate parts. For example a $6,000 nondeductible basis divided by a $60,000 total IRA balance is only 10% nondeductible. Meaning only 10% or $600 of the Roth conversion is nontaxable.
The analogy is: Like you can’t take a sip of your coffee without getting part coffee and part cream so too you can’t withdraw from your IRA assets without getting part traditional and part nondeductible.
Most people just submit to this fact and either avoid nondeductible contributions while they have an IRA balance or make them and then engage in regular Roth conversions to begin the process of converting all your pre-tax assets to Roth. However, there is another way.
As I explained in “Q&A: Can I Do Backdoor Roth and a Reverse Rollover to a 401(k) In the Same Year?,” if you transfer your pre-tax IRA balance into your 401(k) or other employer sponsored retirement account in a reverse rollover, then your nondeductible basis must be left behind in the IRA.
This means that the reverse rollover is like a centrifuge that separates the coffee from the cream. All the pre-tax coffee IRA balance is rolled into the 401(k) plan leaving behind only the sweet cream of the post-tax nondeductible basis.
After all the pre-tax assets are out of the way, you can cleanly convert the entire IRA, which is all nondeductible basis, to a Roth IRA without incurring additional tax. What a great deal!
The one catch on this plan is that your employer retirement plan documents will need to be willing to accept any type of IRA assets. In the past, there used to be regulations that only permitted IRA Rollovers or assets from other employer retirement plans be rolled into your existing employer’s retirement plan. Even though the IRS has released those requirements, many employer retirement plan documents still only permit IRA Rollover accounts be rolled into their plans.
This is why it is best practice to keep your IRA Rollover and IRA Contributory funds separate.
If you have an excepting employer retirement plan, you could consider rolling the pre-tax funds into your 401(k) this year while converting your nondeductible basis cleanly to a Roth IRA, perhaps even as a part of a systematic Roth conversion strategy.
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