When Back-Door Roth IRA’s Fail – The IRA Aggregation Rule

Full Transcript:

This is one way that back-door Roth IRAs end up being a massive tax headache.

I love helping people get more money into tax-advantaged accounts so they can grow their wealth while reducing their future tax burden. However, it’s really important that this is done correctly, and I want to talk about a common mistake that people make when looking at these options. Let’s use Jane as a hypothetical example of looking at when a back-door Roth IRA can really cause an issue when it comes to your taxes.

So, Jane wants to save more money, and she heard about the back-door Roth IRA, knowing that she makes too much to put money directly into a Roth IRA. So, Jane opens an IRA and she puts $7,000, the maximum for 2024, into this IRA. Now, she has this is after-tax money and does not deduct it from her tax return due to her income. Jane then later converts this $7,000 to a Roth so that it can then grow tax-free. Now, normally this would be all well and good, except for Jane also happens to have another IRA and wasn’t aware of the IRS’s IRA aggregation rule.

So when Jane left her previous company, she rolled over her 401(k) into a rollover IRA. And, so she has $133,000 in this pre-tax rollover IRA. Now, in the IRS looks at her conversion, when they look at her tax return, they aggregate her IRAs and then do the conversion on a pro-rata basis. So, when we sum this up, Jane’s total IRA balance is $140,000, with 5% of it being after-tax and 95% of it being pre-tax.

So this $7,000 conversion that she did, even though she converted the entire account and this is in a separate account, in the IRS view, it doesn’t matter. She converted 5% of $7,000 or $350 that was after-tax. And she converted $6,650 of pre-tax to Roth. So this means that she’s going to have a surprise tax bill because this $6,650 is now taxable income. In addition to that, she is now carrying a $6,600 after-tax basis that she has to report on future tax returns or else she can get double taxed on that money. This is a tax nightmare. It’s not only a surprise, but it adds complications to your future returns. Unfortunately, this is a common scenario when people roll money from 401(k) ‘s into IRAs but still want to do a back-door Roth.

A couple of things that I recommend you consider. One, if you have an old 401(k). Look at other options for where you can put that money if you want to consolidate accounts. One option may be rolling it directly into your current 401(k). Now, if you’ve already rolled into an IRA, check with your current 401(k) provider to see if you can and if it makes sense for you to then roll it back into your current 401(k).

Regardless of what you do, I encourage you to review these situations with your tax provider and your financial professional, as they can be very complex and can have massive tax pitfalls or massive upside when done correctly!