Unlike traditional IRAs or 401(k) accounts, the Roth IRA is funded with after-tax dollars and the investments in the vehicle grow completely tax free. Not only that, but since Roth IRA principal balances have already been taxed, they can be withdrawn tax-free at any time.
Roth IRAs have certain limits. You can only contribute $6,000 annually between both your traditional and Roth IRAs ($7,000 if you’re 50 or older). Also, you don’t get tax breaks if your adjusted gross income (AGI) is over $140,000 – that means no tax deductions on traditional IRA contributions and no Roth IRA direct contributions at all. Well, at least not at first.
Someone with an income over $140,000 can still open a Roth IRA by utilizing a backdoor conversion, where funds from a traditional IRA or 401(k) are rolled into a Roth IRA. But backdoor Roth IRA conversions can be tricky, especially if you have nondeductible contributions or multiple IRAs. You’ll need to be cautious of the Aggregation Rule if you want to avoid a surprise tax bill during a backdoor Roth IRA conversion.
What Is the IRA Aggregation Rule?
In the end, there can only be one. The Aggregation Rule is the IRS’s way of consolidating all traditional IRAs into one vehicle, regardless of how many individual accounts a person holds. Over time, it’s not uncommon for a single person to accumulate multiple IRA accounts. Note that the Aggregation Rule doesn’t apply to Roth IRAs since all Roth contributions are after-tax.
The Aggregation Rule works as follows. All IRA accounts (except Roths) owned by each individual person are treated as one large account. It doesn’t matter if you have one SEP IRA and one traditional, or a different traditional IRA opened at three different brokers. If it’s not a Roth IRA, it’s getting thrown into a pile.
Now here’s the tricky part – since all IRA assets in non-Roth accounts are combined, they’re treated as a single entity for tax purposes. This creates several potential headaches, especially when planning a backdoor Roth IRA conversion. More on that later.
Why Have an Aggregation Rule?
The Aggregation Rule was devised to prevent wealthier individuals from benefiting too much from the preferential tax treatment provided by traditional and Roth IRAs. However, the rule does have some pros and cons. Having all IRA accounts treated as a single tax entity can be advantageous when it comes time for required minimum distributions (RMDs). Let’s say you have two traditional IRA accounts, one that holds physical real estate and another that holds a combination of stocks and bonds. You can sell the liquid stocks and/or bonds from the one IRA account to cover the distribution for both, leaving the illiquid real estate untouched.
The Aggregation Rule will likely only cause complications if you have nondeductible contributions in your IRAs. If your income fluctuates, you could find yourself making both deductible and nondeductible contributions to multiple traditional IRA accounts. You can probably foresee where the complications arise here. Since IRA accounts are aggregated, both deductible and nondeductible contributions get combined into one pot where tax obligations are calculated on a pro-rata basis.
If you have one account with $50,000 of deductible contributions and one with $50,000 of nondeductible contributions, you’ll be paying taxes on 50% of your RMDs regardless of which account you draw from. In the scenario listed above, if your real estate holdings were deductible contributions and your stocks and bonds were nondeductible, you’d still be paying taxes as if you tapped the deductible contributions, even though your real estate holdings remained untouched and you only sold stocks.
How Does the Aggregation Rule Affect Backdoor Roth IRA Conversions?
As you might expect, the Aggregation Rule can become the Aggravation Rule when performing a backdoor Roth IRA conversion. Since all traditional IRA accounts are combined, the Aggregation Rule will also apply to backdoor Roth IRA conversions. If you have only pre-tax dollars in your IRA accounts, you don’t need to worry about aggregation on a backdoor conversion – the full amount is taxable at the time of the conversion. But what if you have both deductible and nondeductible amounts in your IRAs and want to make a backdoor Roth conversion?
Under the Aggregation Rule, you’d owe taxes on the pro rata amount of a backdoor Roth IRA conversion regardless of which funds you used in the rollover. For example, let’s say you have $40,000 in deductible contributions in one traditional IRA and $10,000 in nondeductible contributions in another and want to roll $5,000 of the nondeductible contributions into a Roth IRA in hopes of avoiding taxes. According to the Aggregation Rule, taxes would be owed on 80% of the $5,000 rollover amount since 80% of the total account balances were made with pre-tax dollars. So even though the initial $5,000 amount was made after-tax, only $1000 would be rolled over tax-free since only 20% of your aggregate contributions were nondeductible.
Some important notes: inherited IRAs aren’t subject to aggregation, so you don’t need to include them in any calculations. Additionally, each individual is responsible for their own IRA collection, even if they’re married and file jointly. The first word in IRA is individual, after all. Lastly, if you have significant nondeductible contributions in your IRA and want to ease your aggregate tax burden, you can sometimes roll IRA funds into an employer-sponsored plan like a 401(k). Be sure to consult your financial advisor before attempting any backdoor Roth IRA conversions though.
Next Steps with Advanced Retirement Strategies
The long-term benefits of a Roth IRA can significantly improve your quality of life during retirement, stretching your savings to their full potential.
The team of retirement planners at Advanced Retirement Strategies in Bountiful, Utah has the expertise and qualifications to create mega backdoor Roth IRAs on behalf of clients – a maneuver that can create opportunities for a long and comfortable retirement.
Our certified financial planners specialize in helping diligent savers in Davis County, Utah and beyond with $250,000 or more of investable assets (not counting primary residence) prepare for and then transition into retirement.
We would love the opportunity to assist you. Just head to the get started page and set up a free 15-minute quick consult.