Does Inherited IRA Count for Backdoor Roth Conversion?
Do inherited IRAs affect your backdoor Roth? Learn if they impact your personal conversion strategy and the aggregation rule.
Roth IRAs are popular retirement savings vehicles because they offer tax-free growth and tax-free withdrawals in retirement, provided certain conditions are met. While direct contributions to a Roth IRA are generally advantageous, they come with income limitations that can prevent higher earners from contributing. Individuals with income above these thresholds often explore alternative methods to contribute to a Roth account.
Backdoor Roth Conversion Overview
A backdoor Roth conversion provides a strategy for individuals whose income exceeds the direct Roth IRA contribution limits. This two-step process begins with making a non-deductible contribution to a traditional IRA. A non-deductible contribution means the funds are contributed with after-tax money, and no upfront tax deduction is taken for the contribution.
The second step involves converting the traditional IRA balance, including the non-deductible contribution, into a Roth IRA. This conversion allows individuals to bypass the income restrictions that apply to direct Roth contributions. These transactions must be reported to the Internal Revenue Service (IRS) on Form 8606.
Inherited IRA Specifics
An inherited IRA is a retirement account received by a beneficiary after the original owner’s death. Inherited IRAs can be received by different types of beneficiaries, including a spouse or a non-spouse.
The rules governing inherited IRAs vary based on the beneficiary’s relationship to the deceased owner. For instance, most non-spouse beneficiaries are subject to the 10-year rule, which generally requires the entire account balance to be withdrawn by the end of the tenth year following the original owner’s death. An inherited IRA is typically titled in a way that indicates its beneficiary status, such as “John Doe, Beneficiary of Jane Smith’s IRA,” signifying it is held for the benefit of the decedent.
The IRA Aggregation Rule Explained
The IRA aggregation rule, also known as the pro-rata rule, dictates that when converting funds from a traditional IRA to a Roth IRA, the IRS considers the total value of all of an individual’s personal traditional, SEP, and SIMPLE IRAs combined. This aggregation occurs as of December 31st of the year in which the conversion takes place.
The purpose of this rule is to determine the taxable portion of a Roth conversion. If an individual has any pre-tax (deductible) money in any of their aggregated IRAs, a proportionate amount of the conversion will be considered taxable, even if the individual only intended to convert the non-deductible portion of one IRA. The IRS prevents individuals from “cherry-picking” only the after-tax funds for conversion. Form 8606 is used to track non-deductible contributions and to calculate the taxable and non-taxable portions of conversions, ensuring accurate reporting of the basis. This rule applies only to an individual’s own IRAs and does not combine with a spouse’s IRA accounts.
Impact of Inherited IRAs on Backdoor Roth Conversions
Inherited IRAs are generally not aggregated with an individual’s personal traditional, SEP, and SIMPLE IRAs for the purpose of the pro-rata rule when performing a backdoor Roth conversion. The rationale behind this distinction is that inherited IRAs are treated as separate accounts with their own specific ownership and distribution rules. They are not considered part of an individual’s own aggregated IRA balance for this particular tax calculation. Consequently, the existence or value of an inherited IRA does not complicate or make taxable a “clean” backdoor Roth conversion of an individual’s own after-tax funds. The aggregation rule applies strictly to IRAs that an individual personally owns and contributes to.