Backdoor Roth IRA conversion: Tax-free? / When you make a nondeductible contribution to a traditional IRA and you immediately convert it to a Roth IRA, 100% of the conversion is nontaxable, right? Not necessarily.

Robert Klein for MarketWatch writes: You may be asking yourself, how it could be taxable since you didn't get a tax deduction for the contribution to your IRA. What about the backdoor Roth IRA conversion strategy?  Before I get too far ahead of myself, let me back up and review some basics about taxation of deductible versus nondeductible IRA contributions and taxation of Roth IRA conversions that is relevant to this discussion.

Deductible vs. nondeductible IRA contributions

In 2013, the maximum you can contribute to all of your traditional and Roth IRAs is the lesser of (a) $5,500 or (b) your taxable compensation for the year. If you're 50 or older, the limit is $6,500. You can make contributions to a traditional IRA until age 70-1/2.

Without getting into details, the ability to take a deduction for part or all of a contribution to a traditional IRA is dependent upon three things:

• Whether you're covered by a retirement plan at work
• Tax filing status
• Amount of modified adjusted gross income ("MAGI")

If you're single and not covered by a retirement plan or if you're married and neither one of you is a participant in a retirement plan, then 100% of your contribution up to the limit is deductible. If this isn't the case, then the amount of your IRA deduction is dependent upon your MAGI and tax filing status.

Taxation of IRA distributions that include nondeductible IRA contributions

What happens when you eventually take distributions from your traditional IRA account that includes nondeductible IRA contributions? The good news is that your nondeductible contributions won't be taxed. All of your earnings, on the other hand will be included in ordinary income. This could be a significant amount assuming that you make nondeductible contributions over many years.

The calculation of the taxable portion of distributions from a traditional IRA account that includes deductible and nondeductible contributions isn't simple. It takes into consideration the cumulative amount of previously-unused nondeductible contributions, or "basis," as a percentage of the previous end-of-the-year value of all of your traditional IRA accounts to determine the taxable amount of distributions in a particular year.

Roth IRA conversion

Getting back to the fact that all earnings on deductible and nondeductible traditional IRA contributions will eventually be taxable, is there a way to minimize the damage? The answer is yes, through a Roth IRA conversion. You can transfer, or convert, part, or all of your traditional IRA to one or more Roth IRA accounts. This will eliminate taxation of distributions from your Roth IRA accounts down the road, including all earnings from the date of conversion, provided you comply with certain rules.

The trade off for obtaining this favorable result is taxation of the value of the transfer amount from your traditional to Roth IRA on the date of conversion. The conversion is treated as a withdrawal from your traditional IRA, except that the 10% early withdrawal penalty doesn't apply if you're under age 59-1/2.

The simple backdoor Roth IRA conversion strategy

The plot thickens. What if you made nondeductible contributions to the traditional IRA account that you're converting to a Roth IRA? Aren't the nondeductible contributions nontaxable? The answer is "yes," however, only in a limited situation.

Let's suppose that you're 30 years old, you don't have any traditional IRA accounts, you make a maximum contribution of $5,500 to a traditional IRA, you're covered by a retirement plan at work, and your MAGI exceeds the level for receiving a deduction for your contribution. After your nondeductible traditional IRA contribution has been credited to your account, you can immediately do a Roth IRA conversion. Since there are no earnings, 100% of your conversion will be nontaxable. This is referred to as a backdoor Roth IRA conversion.

See “Two Steps to a Nontaxable IRA for High Income Individuals” for an example of the potential power of using this strategy over an extended period.

Don't forget about other traditional IRA accounts

Let's assume in our previous example that you have another traditional IRA account that was rolled over from a 401(k) plan with a value of $100,000. Would 100% of your backdoor Roth IRA conversion still be nontaxable?

The nontaxable amount of your Roth IRA conversion would be equal to your conversion of $5,500 multiplied by a fraction equal to your nondeductible contribution of $5,500 divided by the total value of all of your traditional IRA accounts of $105,500, or 5,500 x $5,500/$105,500, or $287. This results in a taxable amount of $5,213 ($5,500 - $287), or 95% of your conversion amount. Quite a different result compared with the situation where you had no other traditional IRA accounts.

The backdoor Roth IRA conversion is a great strategy for transferring a nondeductible tax-deferred IRA contribution into a tax-free situation provided that (a) you have no other traditional IRA funds, or (b) the value of your other IRA's is less than or equal to the basis in your IRA accounts.