This a great question that is commonly asked amongst the finance, investment, and retirement community.
Back-Door Roth IRA can be a great way to work around the limitations imposed on the Roth IRA contributions in various situations. However, there are some facets that should be mentioned and those are that there are certain tax implications for individuals with existing IRAs. Another aspect to consider is that proper procedures should be implemented to document the initial non-deductible IRA contribution and the subsequent conversion.
The only “catch” is this: if you end up converting a your non-deductible, Traditional IRA contribution to a Roth, the conversion maintains its tax-free composition as long as you do not possess any additional IRA money (Rollover IRAa, SEPs, SIMPLEs, etc…). Your conversion is taxable in relation to your overall IRA holdings, on a pro-rata basis.
Oftentimes, this concept is misunderstood by a multitude of investors. Separating non-deductible IRAs from Traditional IRAs doesn’t make a difference in the end, the pro-rata taxation within the conversion still applies. Another component that is often overlooked in this process is properly documenting the non-deductible contribution within the IRS Form 8606.
As mentioned above, if you do not possess any traditional IRA money, then the “back-door strategy” is a good route to take, due to funds being held in qualified retirement accounts (401 (k), 403 (b), 457, etc…) are excluded from pro-rata tax consideration. However, this is not the case for your spouse if she has pre-rad traditional IRA money, as her conversion would be subject to pro-rata taxation. In an ideal world, your spouse would be able to avoid this situation by transferring her traditional IRA into a new employer’s qualified plan, yet there are certainly some tradeoffs to be had with that option as well.
Here’s the optimal advice: be careful and always consult with your CPA before coordinating such changes and transactions. Review the following for additional guidance: