Individuals with Modified Adjusted Gross Income in excess of IRS-specified limits (see 2013 limits, 2014 limits) are not permitted to make contributions to Roth IRAs. However, ability to convert non-deductible IRAs to Roth without regard to income effectively removes the Roth contribution limitation for many.

The rules allow you to make a non-deductible contribution to a traditional IRA and then immediately convert it by rolling over that balance into a Roth IRA. For those who don’t have existing IRA balances, this technique works well and creates no tax consequences.

However, those with IRA balances may be surprised with a tax bill when reporting the transaction for tax purposes. Here’s why. Let’s say that John has an existing IRA with a current pre-tax balance of $100,000. John makes a $5,500 nondeductible contribution and converts it by rolling that amount into a new Roth IRA account. The IRS pro-rata rule stipulates that John cannot selectively convert just the non-deductible contribution. Even if he opened a brand new IRA specifically to accept the non-deductible contribution, all of his IRA balances would be aggregated to determine the taxable amount of his conversion.

The amount excludible from tax is the ratio of total non-deductible contributions divided by the balance of all individual’s IRAs. In this case, the exclusion ratio will be equal to $5,500/($100,000 IRA balance + $5,500 non-deductible contribution), which would mean that John would pay income tax on 94.8 percent of his non-deductible contribution ($5,213).

Note, that John could avoid this pro-rata rule by first rolling over his IRA balance to a qualified plan or 403(b) account and then converting the remaining after-tax amount to a Roth IRA.

First Allied Retirement Services developed a variety of tools, reports, and materials to assist you in effective communication about these and other important retirement topics. The rules are complex and to succeed you need to either become an expert or align yourself with the right partner. We are available to be an extension of your team. Retirement Services consultants are ready to partner with you in presenting solutions to your clients and prospects. But we don’t stop there; we help you implement and maintain the plan in partnership with nationally recognized record keeping vendors to offer a complete plan solution. You can reach us at (888) 926-0600 or via email to pensions@firstallied.com.