I may not be the world’s foremost expert on Backdoor Roth IRAs, but I’d be very surprised if I wasn’t in the Top Ten. I’ve been helping people with a Backdoor Roth IRA nearly since the beginning (i.e. 2010). I think at this point I’ve seen every mistake, certainly 99% of them. Most of those are demonstrated somewhere in the 1300 post comments section on my Backdoor Roth IRA tutorial. I am continually amazed how complicated people can make something that can be so simple. I mean, the only possible way it could be made simpler is if Congress would just allow high earners to contribute directly to a Roth IRA. Today, we’re going to go through the most common ways to screw up the Backdoor Roth IRA. But first, a brief instruction on how to do it “right.”
- Step # 1 Contribute $5,500 to a traditional IRA during the calendar year, investing the money into a money market fund
- Step # 2 Convert to a Roth IRA the next day, investing the money into your selected investment fund
- Step # 3 Follow the written IRS instructions to fill out Form 8606 properly or double check that your tax preparer did so
It really is that simple. Which makes the rest of this post rather amazing actually. But sad experience has convinced me that this post must be written. Perhaps the biggest mistake is not doing your Roth IRA through the backdoor when your income was so high that you had to. That used to be easier to fix prior to 2018. Now you can’t do recharacterizations (no more Roth conversion horseraces) anymore, so it is even more important that you do it through the backdoor if there is any doubt at all as to whether your income will be too high for a direct Roth IRA contribution.
17 Most Common Backdoor Roth IRA Errors
# 1 Trickling In ContributionsThe Automatic Millionaire. They divide up their $5,500 contribution into 26 biweekly periods and every time they get paid, they put a little money into the IRA. If married, they do it for their spouse too. Maybe it makes their budgeting easier, I don’t know. Perhaps they learned about the benefits of periodic investing/dollar cost averaging and want to try to do that. Some of these people even do the conversion step each time they make a contribution. But by the end of the year, they’ve made over 100 transactions when they could have done four (halve those numbers if you’re single.) I don’t know about you, but I’ve got better things to do with my time than do an extra 100 transactions that I didn’t have to do. Even if you put the contributions on auto-pilot and only do the conversion at the end of the year, you’re still overcomplicating things (not to mention creating some tax drag.) Don’t do this. If you make enough money that you have to contribute to a Roth IRA through the backdoor, you make enough to make the contribution all in one lump sum. Do your Roth IRA in January, your spouse’s in February, and then move on to the 401(k) or 529s or whatever in later months.
# 2 Not Making the Contribution During the Calendar Year
Here’s another one that is super common, so common there’s an entire post about how to fix it. Technically, it’s not an error because you are allowed to contribute to an IRA up until tax day in April of the next year. But don’t do it if you can avoid it. The problem is that people learn about the Backdoor Roth IRA and realize it’s already past the new year and they want to do a contribution for the previous year. Or they procrastinate. Or they do the first step and then forget to finish. So the very first time they do the Backdoor Roth, they’ve got to do a more complicated version. It’s way easier to do the 8606 when it looks the same every year!
# 3 Not Doing The Conversion During the Calendar Year
Here’s a third one that isn’t technically an error. I mean, it’s not illegal or anything because there is no deadline for a conversion. You can do the conversion step now, later in the year, next year, or in 30 years without breaking any rules. But it makes your 8606 more complicated. And the longer you wait for the conversion step, the less tax-free growth you will see.
# 4 Not Knowing The Pro-Rata Rule
Now we’re starting to get into where you’re actually breaking the rules. Line 6 of IRS Form 8606 (the form on which the Backdoor Roth IRA is reported) requires you to list the total you have in traditional IRAs, rollover IRAs, SIMPLE IRAs, and SEP-IRAs (but not Roth IRAs, 401(k)s, or any other type of retirement account) as of December 31st of that tax year.
You want this number to be zero. Make it zero.
# 5 Choosing the Wrong Way to Deal with a Tax-Deferred IRA
So how do you make it zero? You have two choices. If the account is small, it is best to just convert it and pay the taxes. Not only does that require little hassle, but it also makes your Roth IRA bigger. If the tax-deferred IRA is large, you probably don’t want to pay the tax bill on that. So you should roll it over into your employer’s 401(k) or 403(b) or your own individual 401(k). Don’t have a 401(k)? Go do some surveys online, get yourself an Employer Identification Number (free and takes 2 minutes online), open an Individual 401(k), roll the tax-deferred IRA in there, and get on with your Backdoor Roth IRA. There’s no minimum self-employed income required to open an Individual 401(k). I don’t think you actually even have to have any income, but I’d try to get yourself at least $10 of profit for your “business.” Technically you don’t have to do this step before doing the contribution and conversion, you have until the end of the year as long as you don’t put your contribution into this same IRA. But don’t put it off. The deadline is December 31st and things get really busy at investment companies the last week of the year.
# 6 Open Your Individual 401(k) At The Wrong Place
My individual 401(k) is at Vanguard. It’s perfectly fine except for two very minor points. The first is that you have to use the more expensive investor shares instead of the cheaper admiral shares. The second is they don’t accept rollovers. If you’re opening an individual 401(k) mostly or partially in order to rollover a tax-deferred IRA to allow you to do Backdoor Roth IRAs, DON’T DO IT AT VANGUARD. Do it at eTrade, Fidelity, or Schwab. If I had it all to do over again, I’d do it at eTrade and just buy Vanguard ETFs. I may even move mine over there for the cheaper expense ratios if I ever get over my inertia.
# 7 Not Doing an 8606
Some people, including both those who prepare their own taxes and those who get help, simply don’t include Form 8606 on their taxes. Not only is this illegal, but it will likely end up in you paying too much in tax. The good news? You can go back and file 1040Xs for the last 3 years, include the 8606 this time, and fix it.
# 8 Using a SEP-IRA or SIMPLE IRA instead of a 401(k)
There are lots of resources out there that talk about the merits of using a SEP-IRA or SIMPLE IRA for your side gig or even your practice. That advice was probably fine pre-2010. It’s fine for non high-earners too. But it’s not fine for you, because of the pro-rata rule. An individual 401(k) is a little more paperwork, but it’s not bad. It has to be opened before the end of the calendar year, unlike a SEP-IRA, but is that too much to ask? I mean, you don’t even have to make the contributions before the end of the calendar year, you just have to open it. It has higher contribution limits than the SIMPLE IRA and you can max it out on less income than a SEP-IRA. What’s not to like? Nothing.
# 9 Fearing the Step Doctrine
Lots of people and their advisors are worried about The Step Doctrine. This is an IRS doctrine that says if the sum of all the parts is illegal, the transaction is illegal even if all the individual steps are legal. People have worried the IRS could apply this doctrine to the Backdoor Roth IRA, even though they never did to any single person in the last 8 years, tens or hundreds of thousands did a Backdoor Roth IRA every year, you don’t report the dates of the contributions or conversions to the IRS, and the most prominent financial publications in the land have written about it. “Too risky,” the misguided advisors said. They recommended you wait months or even years between the contribution and conversion steps so you could argue to the IRS that you really didn’t contribute to a non-deductible traditional IRA just to convert it to a Roth. And then somehow did the same thing the next year. Give me a break. I practically dared the IRS to audit me on this point. No dice. At any rate, just this year Congress clarified that I was right, so consider this my victory lap. To be clear, you do NOT have to wait any period of time between the contribution and conversion. The next day is fine.
# 10 Confusing a Backdoor Roth IRA and a Roth Conversion
I know, I know. They both have the word Roth in them. They must be the same thing. The Backdoor Roth IRA even includes a conversion step, so I suppose it shouldn’t be surprising that people get confused. But there is a key difference. When you do the conversion in the Backdoor Roth IRA process, there is no tax cost. With a Roth conversion, there is almost always a tax cost of some kind. A Backdoor Roth IRA is a no-brainer. Deciding whether to do a Roth conversion requires weighing a number of competing factors and often making assumptions about an unknown future. Don’t confuse the two.
# 11 Confusing a Backdoor Roth IRA and a Roth 401(k) Contribution
While we’re on the subject of confusing stuff, here’s another one. A Backdoor Roth IRA is not the same as a Roth 401(k) contribution. With a Roth 401(k) contribution, you’re trying to decide which is better — tax-deferred or tax-free. That can be a difficult decision. With a Backdoor Roth IRA you’re choosing between taxable and tax-free. That’s not tricky. That’s a no-brainer. Just do it.
# 12 Forgetting the I in IRA = Individual
INDIVIDUAL Retirement Arrangement. That means one for you and one for your spouse. $5,500 each ($6,500 if 50+). That means you each fill out your own 8606 each year. That means if one of you can’t do a Backdoor Roth IRA due to your employer using a SIMPLE IRA or you have some huge SEP-IRA you can’t get rid of (online surveys are just too hard) your spouse can still do one. Your spouse doesn’t even have to have any income, as long as you have enough income to “cover” him.
# 13 Not Understanding What Basis Is
Line 2 of Form 8606 asks what your basis is.
Basis is money that has already been taxed, so if you convert it, there is no tax cost. The instructions for that line say:
Generally, if this is the first year you are required to file Form 8606, enter -0-. Otherwise, use the Total Basis Chart to find the amount to enter on line 2. However, you may need to enter an amount that is more than -0- (even if this is the first year you are required to file Form 8606) or increase or decrease the amount from the chart if your basis changed because of any of the following:
- You had a return of excess traditional IRA contributions (see Return of Excess Traditional IRA Contributions, earlier).
- You received part or all of a traditional IRA (see the next to last bulleted item under Line 7, later)
- You rolled over any nontaxable portion of your qualified retirement plan to a traditional or SEP IRA that wasn’t previously reported on Form 8606, line 2. Include the nontaxable portion on line 2.
This line confuses people more than any other on Form 8606. Here’s a tip. Enter $0. That’s probably right most of the time and certainly right if you’re doing your Backdoor Roth IRA the way I recommend you do so (i.e. contribution and conversion steps both during the calendar year).
# 14 Skipping Form 8606 Lines 4-13
See that little box there by line 3? The one that says skip most of the form (and which didn’t use to be on the 8606)? That only applies to people who didn’t do a Roth conversion during the calendar year. If you did your Backdoor Roth IRA the way I tell you to (contribution and conversion during the calendar year) you don’t get to skip those lines. That’s because you did a Roth IRA conversion during that tax year. Those lines aren’t so bad. Just follow the instructions.
# 15 One Divided by One is One, Not Zero
Math time. See line 10 on Form 8606? It makes you do math. See?
Usually line 9 is going to be $5,500. So is line 5, at least if you’re doing your Backdoor Roth IRA the way I tell you to (contribution and conversion during the calendar year.) $5,500/$5,500 = 1. For some reason, a lot of people think $5,500/$5,500 = 0. Want to pay too much in tax? Put 0 on line 10.
# 16 Worrying About Pennies
Here’s another thing that throws off so many people I wrote an entire post about it. These folks make their contribution, then a little while later do the conversion step. Even if they kept things really simple, doing the conversion shortly after the contribution and leaving the money in a money market fund while it was in the traditional IRA, there is likely a little more than $5,500 in the traditional IRA when it comes time to make the conversion. So one of two things happens. Either you convert a little more than $5,500 and have to pay taxes on the amount above $5,500 or you leave the amount above $5,500 behind in the traditional IRA. If the amount is less than 50 cents, don’t worry about it. Nobody cares. On your taxes, the IRS is perfectly fine with you rounding everything to the nearest dollar. If the amount is more than 50 cents, then try to include it in the initial conversion or do a second conversion if the IRA custodian will allow it. If they won’t, no big deal, just fill out the 8606 right (there will be a few dollars on line 6) and convert it next year with your next Backdoor Roth IRA (and do it right this time so the amount left behind is < $0.50). Honestly though, even if it is a buck or two, if you only round to three places like line 10 tells you, it still rounds to 1.000.
# 17 Not Checking Your Work
Whether you prepare your taxes yourself, or you pay somebody else to do it, you need to check Form 8606 before it is submitted. It is actually more complicated to fill out 8606 using Turbotax than to do it by hand (so if using Turbotax see Harry Sit’s excellent tutorial). Either way, you need to check your work. So what do you check? You check lines 15c and 18. These lines should have $0 on them (not $5,500). If you’re not doing your Backdoor Roth IRA the way I recommend (contribution followed rapidly by the conversion both within the calendar year), there may be something else on one of those lines, but it should be a whole lot closer to $0 than $5,500.
If you have $5,500 on either of those lines, you’re going to be paying tax twice on the same money and you’re throwing away a couple thousand bucks. Be sure to check your spouse’s too.
That post ended up being longer than I expected, but I hope it is useful to those of you who are still becoming familiar with the Backdoor Roth IRA process. Don’t worry, if you do it right all you have to do next year is copy the previous year’s form.
What do you think? What other ways do people screw up their Backdoor Roth IRA? Comment below!