By Dr. James M. Dahle, WCI Founder
Every March and April I am absolutely inundated with Backdoor Roth IRA questions. This year was no different and I found my prior post on 17 Ways to Screw Up a Backdoor Roth IRA to be inadequate. Not only are you guys incredibly good at finding new ways to screw Backdoor Roths up, but that post focused too much on the errors and not enough on the solutions once the errors have been made. I haven't given up on prevention, but I am now focusing more on treatment.
For a process that seems so incredibly simple to me, it can be amazing all the different ways to screw it up. In 2019, I noticed a couple of trends in the questions I was getting that probably deserve some time on the blog. Before we get into them, let me explain the VERY SIMPLE way to do a Backdoor Roth IRA. There are essentially six steps. I'll go over them and then go over how to fix errors that occur with each step.
6 Steps to Successfully Contribute to a Backdoor Roth IRA
- Step #1: Contribute to traditional IRA ($6K, $7K if 50+ for 2019).
- Step #2: Invest the money in a money market fund.
- Step #3: Move money from traditional IRA to Roth IRA (i.e. a Roth conversion).
- Step #4: Invest in your preferred investment (typically a stock, bond, or balanced index mutual fund).
- Step #5: Ensure you have no money in a traditional IRA, SEP-IRA, or SIMPLE IRA on December 31st of the year you do the CONVERSION step.
- Step #6: Report the transactions correctly on your taxes by filling out Form 8606.
Seriously. That's it. If you can do a cholecystectomy, you can do this. If you can work up a pulmonary embolus appropriately, you can do this. If you can manage hypertension well, you can do this. If you can fill a cavity, you can do this. Super easy.
However, people still manage to screw up on EACH of those six steps. Let's go through the mistakes people make, step by step.
How to FIX Backdoor Roth IRA Mistakes
Step #1 Error: Contributing Directly to a Roth IRA
An error that commonly occurs with a first Backdoor Roth IRA is that people simply don't realize that their income is too high to do a direct Roth IRA contribution. So instead of doing it indirectly (i.e. going through the Backdoor), which is no big deal even if you're under the limit, they contribute directly to a Roth IRA. Then they realize their Modified Adjusted Gross Income (MAGI) is over $137,000 ($193,000 Married Filing Jointly) for 2019. Now what?
Enter the Recharacterization
Well, now you have to recharacterize the Roth IRA contribution to a traditional IRA contribution. This basically makes it as though you never contributed to a Roth IRA but contributed to a traditional IRA instead. You usually have to call your IRA provider to get this done, but it's no big deal.
You have until the due date of your tax return to do this (including extensions). So if you did an IRA contribution in January of 2018 for the 2018 tax year, you have until October 15, 2019 to do a recharacterization. There's no penalty or anything to do it. You can do the opposite as well if you contributed to a traditional IRA but meant to contribute directly to a Roth IRA.
Bear in mind that starting in 2018, you can no longer do recharacterizations of Roth CONVERSIONS (not contributions). This eliminated the “Roth IRA Conversion Horserace” technique for tax reduction.
Until recently, I had thought there was a waiting period after a recharacterization to then reconvert the money to a Roth IRA. However, that rule was only for recharacterizations of conversions, not contributions. There has never been a waiting period for a recharacterization.
Any gains that occur before the final conversion are, of course, fully taxable at your ordinary income tax rate in the year of the final conversion.
Step #2 Error: Not Investing in a Money Market Fund in the Traditional IRA
I ran into a new issue this year from a couple of people. What happens if you LOSE money in between the contribution and conversion step? This problem is easily avoided by using an investment like a money market fund that does not go down in value for that time period, but some people fail to do so and end up losing money. When they work their way through their IRS Form 8606, they discover they have basis left over that they can then carry forward indefinitely for years! No big deal, it just makes your paperwork more complicated. Perhaps at some point in the future you'll do a Roth conversion of tax-deferred money and this carry forward basis will reduce the tax on that event.
What if you MADE money in the account between contribution and conversion? This actually happens most of the time, so I wrote an entire post on it called Pennies and the Backdoor Roth IRA. Technically, any money earned between the contribution and conversion step is fully taxable at ordinary income tax rates in the year of the conversion. If it is less than 50 cents, you just ignore it. More, you report it on your 8606 and pay taxes on it.
If it is still in the traditional IRA, either do another tiny Roth conversion or leave it there until you do next year's Backdoor Roth IRA process, either is fine. If you were smart and just used a money market fund and did the conversion as soon as your IRA provider allowed it (usually less than a week and sometimes as early as the next day), this won't be much money and there won't be much tax due.
Step #3 Error: Forgetting to Do the Conversion
If you were dumb and forgot to do the conversion step for eight months afterward, it could be a huge gain you're paying taxes unnecessarily on. No way to fix this one, just pay your stupid tax and move on.
Step #4 Error: Forgetting to Invest the Roth IRA Money
Even worse than paying taxes on a huge gain, is not getting the gain in the first place because you left the money sitting in cash for months. No way to fix this one either. Your “stupid tax” this time comes in the form of opportunity cost. Just get the money invested ASAP to stop the cash drag. Maybe you even got lucky and the market went down in between contribution and investment so now you get to buy low.
Step #5 Error: The Pro-Rata Rule
Some of the most common questions I get are from people who make a late contribution to a Backdoor Roth IRA. What do I mean by late? Well, you are allowed to make an IRA contribution AFTER the calendar year ends. In fact, you have until tax day, usually April 15th unless you get an extension of up to six months. While it is to your advantage to contribute to retirement accounts as quickly as possible so that money can start compounding in a tax-protected way, I understand that we all have lots of good things to do with our money and sometimes this gets pushed back into the next calendar year. All it really does is complicate your paperwork a bit.
For example, if you made your 2018 IRA contribution in April 2019, instead of reporting both the contribution and the conversion on your 2018 taxes, you would report only the contribution there. The conversion would be reported on the taxes for the year you did the conversion, i.e. your 2019 tax return due in April 2020. Your 2018 IRS Form 8606 becomes a little simpler and your 2019 IRS Form 8606 becomes a little more complicated. Not a big deal if you can follow the simple instructions.
What confuses people, however, is the pro-rata rule. This is the rule that says you need to empty out your traditional IRA by December 31st of the year you do the conversion. Since these folks have never filled out a Form 8606 (or apparently read the instructions) they assume that for a 2018 contribution they need to have a balance of $0 at the end of 2018, even if they didn't do the conversion step until 2019. That's simply not the case. The pro-rata rule isn't applied until the year of the conversion, i.e. December 31st, 2019.
Emptying the IRAs
So how do you empty out those IRAs? You usually have two choices.
- Do a Roth conversion of the whole thing. This is what I generally recommend for small IRAs where the tax bill on the conversion would not be too onerous. It is quick, easy, and increases the amount of tax-free assets you have.
- Roll the money into a 401(k) or 403(b), either that of your current employer, that of a past employer, or to your own individual 401(k) if you are self-employed. This is usually a better option if you have a large IRA where you would rather deal with the hassle than pay the tax bill during your peak earnings years.
So how large is large and how small is small? Well, it's going to vary by the person and how much disposable cash they have. Most would consider an IRA under $10K to be small and an IRA over $100K to be large. In between, it's a personal decision as to which would be better for you.
What If You Didn't Empty the IRA?
So what if you screwed this one up? Well, your Backdoor Roth IRA conversion step just got pro-rata'd. There is a tax bill associated with that because most of your conversion was of tax-deferred money rather than post-tax money like it was supposed to be.
The fix for this is going to vary by the individual, but the easiest fix is to simply convert the entire IRA to a Roth IRA now, so you end up getting all your post-tax money into that Roth IRA. Another possible fix is to figure out a way to separate your basis in that IRA, roll the tax-deferred money into a 401(k), and then convert the basis left behind in the IRA.
Do yourself a favor and just empty the darn IRA by December 31st. Keep in mind that this is usually not an instantaneous process, so don't put it off until you're on holiday break at the end of the year.
Step #6 Error: Screwing Up the Tax Forms
Both individual taxpayers and professional tax preparers screw up IRS Form 8606 all the time. In fact, some of them haven't even heard of a Backdoor Roth IRA. (Incidentally, this is one of the best questions to ask while interviewing a potential tax professional—”How many backdoor Roth IRAs did you help last year?”)
The usual fix to this error is to file a 1040X (Amended Tax Return) and a new Form 8606. You can do this for the last three years if necessary. If you didn't file Form 8606 at all, you'll definitely want to do this. The key is to check lines 15c and 18 on Form 8606. They should both be a number very close to zero if the form is being completed correctly.
The tax preparer should NOT be filing Form 5439. If you did steps 1-5 right, this form probably doesn't belong in your tax return.
A lot of people wonder about the 1099-R sent to them by their IRA provider and worry that it was done wrong and that it will cause them to pay tax they shouldn't have to pay. Sometimes the form was filled out wrong, but mostly this is just a lot of anxiety. What gets people anxious is finding something on Line 2a “Taxable amount”. As long as the box on Line 2b is also checked “Taxable amount not determined”, you're golden. Don't worry about it. If it is not, have the IRA provider send you a new, correct form, either with $0 in 2a or the box in 2b checked (usually the latter). Here's what mine looks like every year from Vanguard:
Note that Box 2b is checked, even though they are reporting a taxable amount of $5,500.07 to the IRS.
Again, if you're not sure how to enter this into Turbotax, check out Harry Sit's excellent tutorial. I still occasionally refer to it myself.
Still Confused About the Backdoor Roth?
I wish Congress would just lift the rule against direct Roth IRA contributions for high earners and save us all this hassle, but who knows if that will ever happen.
- Need more help with a Backdoor Roth IRA? Here is my Backdoor Roth IRA Tutorial (along with 1800 comments on it).
- If you did your contribution after the end of the year, check out Late Contributions to the Backdoor Roth IRA.
- The Physician on FIRE walks you through a step by step Backdoor Roth IRA at Vanguard.
- Harry Sit walks you through reporting the Backdoor Roth IRA in Turbotax.
- Here is my prior post on 17 Ways to Screw up Your Backdoor Roth IRA.
- You can hire a professional to help you, either a good financial advisor or a good tax strategist can assist.
- You can also ask your peers for help on the WCI Forum, the Private WCI FaceBook Group, and the WCI Subreddit.
What do you think? Which Backdoor Roth IRA mistakes have you made? How did you fix them? What errors do you see others making? Comment below!