You Can’t Convert a Non-Deductible IRA Contribution Tax-Free in Most Cases

By Joe Cicchinelli, IRA Technical Expert

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You want to make a contribution to a Roth IRA for 2014. As long as you’re working and have compensation (earned income) you can potentially make a Roth IRA contribution of up to $5,500 if you’re under age 50 or $6,500 if you’re age 50 or older this year. However, remember that there’s an income limit for making a Roth IRA contribution. Certain higher income individuals aren’t allowed to make a Roth IRA contribution for the year.

For 2014, if you’re married and filing jointly, and your combined income (what the IRS calls modified adjusted gross income or MAGI) is $191,000 or more, you can’t make a Roth IRA contribution. If you’re single, the MAGI limit for 2014 is $129,000. But there’s a strategy to allow high income individuals to get around the income limits for contributing to a Roth IRA. This loophole is sometimes called a “backdoor Roth IRA conversion.”

There are no income limits to convert IRA money to a Roth IRA, so any high income person can do a conversion. There’s also no income limit to make a traditional IRA contribution, but typically high income individuals can’t take a tax-deduction for it because they participate in a company retirement plan and their income is too high. That leaves you with making a non-deductible traditional IRA contribution, which is allowed.

Generally, when you convert IRA money to a Roth IRA, the conversion is taxable. Some folks have been told that you can simply make a non-deductible traditional IRA contribution and then convert that contribution to a Roth IRA tax-free. In most cases, this strategy does not work because of the pro-rata tax rule.

Under the pro-rata tax rule, if you have other IRAs, including SEP and SIMPLE IRAs, you must look at all the balances of all your non-Roth IRAs when figuring the taxable part of any IRA money you convert to a Roth IRA. It doesn’t matter if your nondeductible IRA contribution was made into a separate IRA either; the rules look at all of your IRAs as one IRA.

When one of your IRAs has nondeductible money in it (also called after-tax funds), then each dollar withdrawn from any of your IRAs will contain a percentage of tax-free funds (the nondeductible funds) and taxable funds (the deductible funds and earnings) based on the percentage (pro-rata portion) of after-tax funds to the entire balance in ALL your IRAs.

So, if you have other IRA money when you make a nondeductible IRA contribution, you can’t just convert that contribution tax-free. You report your after-tax contributions on IRS Form 8606. This form must also be filed with your tax return when you do a Roth conversion.