What is the IRA averaging rule
The IRS has a rule to prevent individuals from using the backdoor Roth IRA to avoid taxes on their contributions. The rule is called the “averaging rule” and applies to any conversion of Traditional IRA funds to a Roth IRA. The averaging rule requires the individual to include all of their Traditional IRA funds in the conversion calculation, even if the funds were not included in the conversion.
For example, suppose an individual has a Traditional IRA with $100,000 in pre-tax funds and makes a non-deductible contribution of $6,000 to a new Traditional IRA. The individual then converts the $6,000 to a Roth IRA. In this case, the conversion will be taxed based on the ratio of pre-tax to post-tax funds in all Traditional IRA accounts. Since the individual has $100,000 in pre-tax funds and $6,000 in post-tax funds, only 6% of the conversion ($360) will be tax-free, and the remaining 94% ($5,640) will be taxed as income.
Conclusion
Individuals should be aware of the averaging rule and the tax implications of a backdoor Roth IRA before making contributions. Consulting with a financial advisor or tax professional can be helpful in understanding the rules and regulations surrounding IRA contributions and conversions.
high net worth individuals, especially those nearing retirement age and with high balances in IRA’s cannot perform this backdoor Roth as the whole balance of the conversion would likely be taxable.
The averaging rule is an IRS rule that applies to any conversion of Traditional IRA funds to a Roth IRA. The rule ensures that individuals cannot use the backdoor Roth IRA to avoid taxes on their contributions. The rule requires the individual to include all of their Traditional IRA funds in the conversion calculation, even if the funds were not included in the conversion. Meaning high net worth individuals, especially those nearing retirement age and with high balances in IRA’s cannot perform this backdoor Roth as the whole balance of the conversion would likely be taxable.
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This tax information is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Booked Financial LLC recommends that you consult with a qualified tax advisor, CPA, financial planner, or investment manager.