3. The IRS uses the pro-rata rule
After creating a backdoor Roth IRA, the IRS will calculate the exact amount of your tax bill pro-rata, which means proportionally. First, they’ll look at the amount in your traditional IRA. Because it’s possible to have multiple traditional IRA accounts, they look at the sum of all your accounts, and not just the one you may be using to convert. Next, they examine how much of this amount is pre-tax versus after-tax contributions. Whatever percentage of your account(s) that’s pre-tax is the same percentage of money converted to a Roth IRA that you’ll owe taxes on.
For instance, if 80% of the money in your traditional IRA is pre-tax, 80% of the money converted to a Roth IRA will be taxable — and there’s no way to only convert after-tax money. If you converted $100,000, you’d owe income taxes on $80,000.
Who should take advantage of backdoor Roth IRAs
Backdoor Roth IRAs generally only make sense for individuals earning over the income limit. If you’re below the income threshold, you can save yourself the effort (and tax implications) of IRA conversions by simply contributing directly to a Roth IRA. If you’re above the income threshold, the process of creating a backdoor Roth IRA may be well worth the effort — especially because Roth IRAs don’t have required minimum distributions, and accounts can grow tax-free for as long as they’re open.