Beware the Traditional IRA, It Just Might Backfire

When I first started learning about personal finance, the default advice pretty much everywhere was for people to roll their 401(k) into a Traditional IRA (TIRA) for greater flexibility of investment choices and low fees whenever they left a job.

I never did this (thankfully!), but I did contribute to a TIRA earlier on in my career when I had maxed out my 401(k) but was looking for an extra place to stash some retirement savings. I’m not sure exactly why I chose the TIRA over the Roth IRA at the time. I think it was a combination of feeling like I should max out the tax-deferred space before my income rose too high to contribute to a TIRA, and the early on snowball effect of getting an extra $1k or so in a tax refund to then invest elsewhere.

Now it’s 7 or so years later and I’m preparing to do a Backdoor Roth IRA for the first time, which has led to me wondering why the heck I ever contributed to a TIRA to begin with. I probably would not have, if I had known about the Pro Rata Rule.

The Pro Rata Rule and the Backdoor Roth

Pro rata simply means proportional. If an account contains both pre-tax and post-tax contributions, the Pro Rata Rule comes into effect when determining what percentage of a distribution from that account is taxable. Since the IRS considers IRA conversions to be a distribution, this is relevant when doing a Backdoor Roth IRA.

For example, say you have $93,500 in tax-deferred money in an existing Traditional IRA and want to do the Backdoor Roth in 2023. You make a $6,500 non-deductible contribution to the TIRA and want to convert it to a Roth IRA.

But you can’t convert “just” that $6,500. You need to determine the percentage of non-deductible dollars in the account as a whole, and pay a proportional share of tax on the remaining pre-tax dollars. In this example that would be $6,500 out of $100k, or 6.5% of the dollars being non-deductible post-tax dollars. So when you convert your $6,500 to a Roth IRA you need to pay ordinary income tax on 93.5% of it, or $6,078.

This also means that $6,078 of your non-deductible dollars are still in the TIRA, so you have to track this total balance year-to-year, which could get messy as you add new non-deductible contributions and re-calculate every year.

You can’t dodge the Pro Rata Rule by opening a new TIRA with a different brokerage and depositing only non-deductible contributions in it. You must consider all of your IRAs to be the “same” account, so this includes Traditional IRAs, Rollover IRAs, SEP IRAs, and SIMPLE IRAs factoring into your total pre-tax dollars calculation.

You might be doing a Backdoor Roth IRA sooner than you think

In 2023, single income filers begin phasing out of being able to directly contribute to a Roth IRA at a Modified Adjusted Gross Income (MAGI) of $138,000, and therefore will have to use the Backdoor Roth IRA in order to get the full contribution amount for the year.

I figured I might never reasonably hit that MAGI figure (it’s adjusted for inflation every year) with my projected salary growth over the next 10 years, when I hope to retire early.

This year though, I’ll be Married Filing Jointly (MFJ) for the first time. And direct Roth IRA contributions begin phasing out for MFJ at a MAGI of $218k. This is only 79% of the total income threshold available to 2 people filing as single status. Oddities like this — where the MFJ limits are not twice those available to single filers — contribute to the existence of a “Marriage Tax Penalty” in certain situations.

It’s easiest to just have $0 in Tax-Deferred IRA accounts

That is, unless you know for certain that you will never need to do the Backdoor Roth IRA. But who knows how your income will develop over time (you might surprise yourself), and those reduced MFJ brackets might sneak up on low six-figure-earners who get married.

I have $6,600 or so in my TIRA. I’m just going to convert it all this year and take the tax hit (nearly $2k between federal and state taxes) so I don’t have to deal with carrying an ever-shrinking chunk of tax-deferred dollars forward every year. Then next year, I can just do the Backdoor Roth IRA with no hitch since my TIRA will have a balance of $0.

Whoops, guess it wasn’t so smart to contribute to a TIRA and reduce my taxable income when I was earning less money and in a lower tax bracket earlier in my career.

So think twice before rolling your workplace 401(k) out into an IRA. It would suck to have a six figure tax-deferred balance in a Rollover IRA that will haunt you while doing Backdoor Roth IRA conversions for the rest of your working career.

One potential saving grace: if your workplace retirement plan offers a reverse rollover, you can roll the IRA into your 401(k) plan or equivalent before doing the Backdoor Roth IRA. According to the Plan Sponsor Council of America, 69% of employer-sponsored 401(k) plans offer a reverse rollover feature. But this leaves nearly 1 in 3 that don’t, so it’s not a guaranteed get out of jail free card.

A friend of mine put himself in this situation and regrets it. He rolled out an old 401(k) that had access to low-fee Vanguard funds into an IRA, and now that that he’s in a situation to do the Backdoor Roth IRA he found out that his new job’s 401(k) doesn’t offer a reverse rollover. Unfortunately, he trusted the overly-simplified financial advice on Reddit and now suffers from a minor annual tax bill and a headache every year when contributing to his Roth IRA.

Final thoughts

While this isn’t something that will make or break your FIRE plan — if you’re in the income range to do a Backdoor Roth IRA, you can afford an annual tax hit of $1500+ per person to satisfy the Pro Rata Rule — it seems to be something that most people don’t find out about until later on in their investing journey, which might have caused them to make different decisions earlier had they known.

It’s also a good idea to keep your taxes as simple as possible, so you can save money by filing them yourself. If you have too many complexities you might resort to paying for a tax professional to figure it out; of course I’m a stubborn DIYer to a fault, so I’ll instead sit for hours reading tax law on the IRS website so I can continue to do my own taxes.

If I had known in my early 20s what I know now, I would have just contributed to a Roth IRA back then instead of a Traditional IRA. It was a slightly less optimal financial decision; I contributed to my TIRA in the 15% federal tax bracket (prior to the TCJA taking effect in 2018), and now I’m converting those contributions and the gains to a Roth IRA in the 24% federal bracket.

It’s not all bad since I’ll have extra money in my Roth IRA that will grow tax-free going forward, but I could have put that money into the Roth IRA cheaper in the past and made my taxes a little bit less annoying this year.

This is just some nuance for Americans to weigh in the decision of which type of IRA to contribute to early in their career, or to consider before doing a 401(k) rollover. The Traditional IRA could cause an unexpected tax surprise for some investors.

Thoughts? Questions? Leave a comment below!