Using Non Deductible IRAs to Get Money Into a Roth IRA
The best of both worlds: tax deferred growth and tax free distributions
If you are not eligible to take an IRA deduction for your contribution to an IRA and you make too much money to make a Roth IRA contribution, then, you might consider making a non-deductible IRA contribution. You can then immediately convert it to a Roth IRA. This is sometimes called a "back door Roth IRA" strategy. Below are the rules that apply.
Non-deductible IRA basics
A non-deductible IRA has the same contribution limits and is subject to the same rules as a Traditional IRA – the difference is how the contribution is treated on your tax return.
You can make non deductible IRA contributions to the same IRA account that has deductible contributions, however, for tracking purposes. I advise you open a separate account for all non-deductible contributions.
With your tax return, you will need to file a form 8606 where you report the amount of your IRA contribution that was non-deductible. This is called your basis.
One of the most effective uses of non-deductible IRAs is for high-income earners. High-income earners can use non-deductible IRAs to contribute to a Roth IRA.
Using a Non-Deductible IRA Contribution to Contribute to a Roth IRA
For those who earn enough money that they are not eligible to make a Roth IRA contribution, they can still contribute money to a Roth IRA in a round-a-bout way. Each year you can make a non-deductible IRA contribution and then convert that non-deductible IRA to a Roth. You can convert your non-deductible IRA to a Roth in the same year you make the contribution.
When you convert an IRA to a Roth IRA, you pay taxes on any amount that is converted that is above your basis. If you have other IRA accounts, your basis must be calculated using a pro-rata formula.
For example, suppose you have $11,000 in a traditional IRA, and you make a $5,500 contribution to a separate IRA account as a non-deductible IRA.
You now have a total of $16,500 in IRAs, 1/3 of it is non-deductible, the other 2/3rds are traditional deductible contributions.
It would be nice if you could convert just the non-deductible IRA portion, however, the IRS looks at all your IRA accounts combined - so if you convert just $5,500, one-third of the converted amount (about $1,815) will be considered basis and the other two-thirds (about $3,685) will be considered taxable income for the year of the conversion. (Note: This tax cost of converting a Roth will be only a small price to pay if your investments do their job and grow tax-free for many years inside your Roth IRA.)
How to Avoid the Pro-Rata Basis Rule
The pro-rata basis rule does not apply if you have all your other retirement money in a 401(k) plan - then each year you make a non-deductible IRA contribution, assuming you immediately convert it to a Roth, the full amount of the conversion is considered basis.
For example, if you have $300,000 in a 401(k) plan and nothing in an IRA, you can immediately fund a non-deductible IRA, and convert it to a Roth. The converted amount is not taxable income as it was all cost basis.
You can roll traditional IRA balances back into an employer plan, such as into 401(k) plan, leaving only your non-deductible IRA balances outside of the plan so that in the future you can use the back door Roth conversion strategy without worry about accounting for pro-rata basis.
On the tax forms required the IRS asks for year-end account balances as of the year you are filing the tax return (and the form 8606), so you would need to roll traditional IRAs into a 401(k) plan before year-end to use the conversion strategy that year.
If by year-end you have no funds remaining in Traditional IRAs, SEPs or SIMPLEs (perhaps because they were rolled into a qualified plan) then, that would leave you free to convert only the remaining non-deductible IRA to a Roth. As said, this move is called a backdoor Roth IRA and is a common practice. Future changes in tax law may take this strategy away, but as of now, it is perfectly fine to do it.
Non-Deductible IRA Mistakes
The most common mistake made with non-deductible IRAs is forgetting to complete the IRS form 8606 with your tax return.
If you have made non-deductible IRA contributions but did not report your basis, you can report it in arrears. See the article called I forgot to file form 8606 for details on what to do.
Another common mistake is thinking you can convert only your non-deductible IRA contributions to a Roth. As discussed above, you have to look at the total of all your IRA accounts when determining the amount of tax owed when you convert to a Roth.