The IRS views all of your traditional IRAs as a single account when determining the taxes you owe on distributions. Unfortunately, from the IRS’s standpoint, “distributions” include Roth IRA conversions. This fact greatly complicates backdoor Roth IRA conversions for people who already hold existing balances in traditional IRAs.
In practice, this means you may owe taxes on money you intend for a backdoor Roth IRA conversion—even if the money has already been taxed. This happens when the IRS’ aggregation rule intersects with the pro-rata rule.
The pro-rata rule states that once money enters an IRA, you cannot separate the portion that’s already been taxed from the portion that was deducted from taxes. You may hear this described as the “cream in your coffee” rule. Once cream hits the coffee, it’s impossible to separate back out the dairy. The same goes for your pre-tax and post-tax IRA contributions.
Let’s say 80% of the funds in your combined IRAs earned tax deductions, and 20% did not. When you undertake a backdoor Roth IRA conversion, you can’t separate out the already taxed funds for conversion, much like the cream cannot be separated from the coffee. In this example, 80% of the money being converted to a Roth IRA would be taxed in a Roth IRA conversion.
If you’re considering a backdoor Roth conversion, speak with a financial advisor to help you manage the process in a way that minimizes the amount of taxes you may owe. It could make sense to roll over some of your money into a 401(k), which is not considered in pro-rata calculations.