Roth Conversions and the Backdoor Roth: Tax Now, Tax-Free Later

December 31 is the date that decides a backdoor Roth. On that day the IRS takes a snapshot of every traditional, SEP and SIMPLE IRA you own, and the snapshot sets how much of a conversion made during the year is taxed. Before getting to it, start with the plain conversion.

What a conversion is

A conversion moves money from a traditional IRA into a Roth IRA. The pre-tax part counts as income that year. After that it is Roth money, growing under the rules from the first lesson on Roth growth, and once the age and five-year tests from that lesson are both met, its growth comes out with no tax at all.

The bracket assumption matters. Cross into the next bracket and the part above the line pays the higher rate. Thresholds change yearly. The IRS publishes them each fall. Check where your taxable income sits before choosing an amount.

Conversions can’t be reversed. For any conversion made from 2018 on, the IRS no longer lets you move the money back, so the tax is owed even if the account falls the next week.

The backdoor Roth

Roth IRA contributions phase out above an income range. Conversions have no income limit. The backdoor Roth uses that gap. Put a nondeductible contribution into a traditional IRA, then convert it.

With no other IRA money, the conversion is nearly tax-free. You already paid tax on the contribution. Only whatever growth accrued between the deposit and the conversion is taxed. File Form 8606 to record the nondeductible contribution and the conversion.

The pro-rata rule

You can’t pick which dollars you convert. The IRS adds up all your traditional, SEP and SIMPLE IRA balances at year end, works out what share of the total is after-tax basis, and applies that share to every dollar you convert, so a single old rollover IRA sitting in another account can turn a tax-free backdoor into a mostly taxable conversion.

Balances in a 401(k) or other employer plan are left out of the sum. That opens the usual fix. If your workplace plan accepts roll-ins, roll the pre-tax IRA money into it before year end. The IRA left behind holds only basis.

When a conversion earns its tax bill

A conversion pays when today’s rate is lower than the later one. Some years are cheaper than others.

• Low-income years, such as a gap between jobs, or the first years of retirement.
• The stretch before required minimum distributions and Social Security start, when taxable income is often at its lowest point in decades and each converted dollar may meet the smallest rate you will see again.
• Any year you can pay the tax from money outside the IRA.

Paying the tax from the IRA shrinks what lands in the Roth. Before 59½, it’s worse. Withheld tax counts as a withdrawal, penalty included.

Where to go from here

That completes the set: Roth growth, early access, the HSA and conversions. Put them to work in order. Pull your latest statements. Mark each balance pre-tax, after-tax or Roth. Look for any old IRA that would trip the pro-rata rule. Then check last year’s return for the bracket you ended in, and sketch how much room a conversion would use before it reaches the next one. Situations differ, and a tax professional can check the figures against your whole return.

Conversions sit next to other retirement tax problems, the Social Security tax torpedo, RMDs and Medicare surcharges, and the course on tax landmines after the last paycheck takes those in turn. Where new contributions should go is settled in the Roth or traditional IRA guide.