3. The IRS uses the pro-rata rule
After setting up a backdoor Roth IRA, the IRS will calculate the exact amount of your tax bill pro-rata, which means proportionally. First, they will look at the amount in your traditional IRA. Because it is possible to have multiple traditional IRA accounts, they look at the sum of all your accounts, not just the one you might be using to convert. Next, they examine how much of this amount is before tax relative to contributions after tax. Regardless of the percentage of your pre-tax accounts, the same percentage of money is converted into a Roth IRA that you owe tax on.
For example, if 80% of the money in your traditional IRA is before tax, 80% of the money converted to a Roth IRA will be taxable – and there is no way to just convert money after tax. If you converted $ 100,000, you owe $ 80,000 income tax.
Who should benefit from backdoor Roth IRAs
Backdoor Roth IRAs generally only make sense for people earning above the income threshold. If you are below the income limit, you can save yourself the hassle (and tax consequences) of IRA conversions by simply contributing directly to a Roth IRA. If you are above the income threshold, the process of creating a Roth IRA can be worthwhile – especially because Roth IRAs do not have the required minimum distributions, and accounts can grow tax-free as long as they ‘re open.