(PUB) Morningstar FundInvestor

December 2013

Morningstar FundInvestor

17

the low end of the phase-out range for married couples ($ 178 , 000 ), and the total range is $ 10 , 000 (the difference between $ 178 , 000 and $ 188 , 000 ). Her allowable Roth contribution amount will therefore be docked by 20% (her $ 2 , 000 overage divided by the total phase-out range of $ 10 , 000 .) Thus, she can make a $ 4 , 400 contribution ($ 5 , 500 reduced by 20% ) to a Roth in 2013 . A complicated mess? You bet. Thus, if it looks like you’re at risk for falling into the phase-out range, it may well make sense to make a nondeductible IRA contribution and then convert to a Roth shortly there- after because contribution limits don’t apply to either maneuver. That way you’re avoiding the phase-out range altogether, as well as the possibility of partial contributions. This maneuver won’t be attractive if you have other traditional IRA assets, however, for reasons outlined in this article. You noted in a previous article that if you have pretax assets in an IRA, you can avoid taxes on your backdoor Roth IRA by rolling those pretax IRA assets into your new employer’s 401(k). But if the employer allows IRA rollovers, does it matter if the rolled IRA is a mix of deductible contributions and rollovers from a prior employer’s 401(k)? Opening a new nondeductible IRA and then con- verting to a Roth IRA shortly thereafter (the backdoor IRA maneuver) won’t typically result in a tax bill— unless, that is, you have other traditional IRA assets that have never been taxed. If you have other tradi- tional IRA assets, the portion of the conversion that is taxable will be based on your ratio of IRA assets that have been taxed (nondeductible contributions) to those IRA assets that have never been taxed (monies rolled over from traditional 401 (k)s, deductible con- tributions, and investment earnings). For this reason, the backdoor IRA conversion may not be a good strategy for people with other traditional IRA assets, such as rollovers from previous employers’ 401 (k)s. However, as you note, a possible workaround is to roll pretax traditional IRA assets into a current employer’s 401 (k). In so doing, you can effectively get

those monies out of your IRA kitty, thereby start- ing with a clean slate with your new nondeductible IRA contribution. In the past, the Internal Revenue Service made a distinction between assets that got into an IRA because they were rolled over from a previous emp- loyer’s 401 (k) plan and those that got into the IRA because the account owner contributed funds directly to the IRA from the get-go. (The former was called a conduit IRA and the latter a contributory IRA , and if these two account types got mashed together, the account was said to be commingled .) The IRS has since relaxed that distinction, however. Now, if you choose to do a reverse rollover—that is, move money from your IRA to your employer’s 401 (k) because you intend to do a backdoor IRA —you only need to make sure of three things: 1 ) that your employer’s plan allows such a transfer; 2) that you’re contributing only pretax IRA monies to the 401 (k) (you cannot move aftertax IRA assets (that is, nondeductible IRA contri- butions) into a 401 (k)); and 3) that your 401 (k) plan is a worthy receptacle for new assets. I have an account, Account A, with traditional IRA money. Could I open a new account, Account B, and make use of the backdoor conversion option for that account only and leave the Account A money in the traditional account? Or is the IRS mixing both accounts and mandating the tax regardless of which account was converted? As appealing as your strategy sounds as a means of doing a tax-free backdoor IRA when you already have other traditional IRA assets, the IRS “pro rata” rule pertains to all of your IRA assets. Therefore, the tax treatment of your new IRA —Account B—would be based on the ratio of money that has never been taxed in all of your IRA s relative to any aftertax monies in all of your IRA s. Assuming you put $ 5 , 500 of aftertax dollars into Account B but had $ 100 , 000 in pretax dollars in Account A, your conversion of Account B would be more than 95% taxable, because more than 95% of your total IRA assets have never been taxed. œ Contact Christine Benz at christine.benz@morningstar.com