By Dr. Jim Dahle, WCI Founder
In personal finance (and in the rest of life), there are no “dumb questions,” and I will try to cheerfully answer every question I'm given. I have certainly asked lots of questions that, in retrospect, seem dumb. But I've been answering this one about Backdoor Roth IRAs for years and years. (If you have no idea what a Backdoor Roth IRA is, read my Backdoor Roth IRA ultimate guide and tutorial first. Seriously. You need to know what it is. If you like, you can read the 3,500 comments below that post where you will see variations of this question asked dozens of times.)
At any rate, I decided long ago to write a blog post about it so I could just link to the post instead of typing out the answer over and over again in comments, the forum, and emails. Now, I'm republishing it for those who missed it the first time. If I sent you a link to this post in response to your question, please don't take personal offense. I don't think you're dumb, but it's way easier for me to post a link to a comprehensive answer to this question than to type this out every time.
Questions I Always Get Asked About the Backdoor Roth IRA
How to Account for the Pennies in Interest
Q.
I just did the Backdoor Roth IRA for the first time, and I was appalled to find out that, over the three days I had that $7,000 in a money market fund in the traditional IRA before conversion, it earned 37 cents in interest. Now, I'm afraid the IRS is going to come after me and repossess my dog. What should I do to keep the IRS at bay?
A.
These are questions that don't get asked by people who have done their own taxes for years. The reason why is they know you don't report cents on your taxes. You just round down or up. If you do a Roth conversion of $7,000.37, all the IRS knows (and cares about) is that you converted $7,000. Seriously, nobody cares about that 37 cents. You just got a free 37 cent Roth conversion!
Q.
But that 37 cents is actually still in the traditional IRA! I didn't actually convert it.
A.
Great. Leave it there until next year. Then, convert it.
Q.
Unfortunately, it turns out it wasn't 37 cents. It was 87 cents. Now what?
A.
You now have a taxable transaction, since you will round that up to $1. You will owe taxes on it. That could be as much as 45-50 cents added to your tax bill! Here's how you report it:
Easy peasy, right? By the way, if your tax preparer doesn't know what to do with it, send him a link to this post. (Dear tax preparer, please don't be offended if you were sent this link. I know the vast majority of your clients don't do Backdoor Roth IRAs.)
Q.
But now it's 2024, and money market funds actually pay interest. Now there is $5.65 still in the traditional IRA!
A.
Great. Same choices. Convert it to the Roth IRA (and owe a couple of bucks in tax on it) or leave it there, get pro-rated this year (paying $2 in tax on that $6), and clean it up on the 8606 next year (where that $6 will be converted tax-free along with your next $7,000 that you contribute for next year.)
More information here:
How to FIX Backdoor Roth IRA Screwups
Opening a “Business” to Get an Individual 401(k) for a Rollover
Here's another little trick a lot of people may not know about. Some people don't want to do a Backdoor Roth IRA due to the pro-rata issue. The Backdoor Roth IRA doesn't work so well if you have a business where you are making SIMPLE IRA or SEP-IRA contributions each year. But it does work very well if the only reason you aren't doing a Backdoor Roth IRA is because you have a big fat SEP-IRA, rollover IRA, or traditional IRA where you are no longer making contributions. (See line 6 of the 8606 above—you want it to be zero if you're doing the Backdoor Roth IRA.) There is always the option to just convert that tax-deferred IRA and pay the taxes on it, but if it is really large, that's probably not a good idea.
So, what can you do? You can start a business.
Step 1: Get an Employer Identification Number (EIN). It only takes five minutes, and it's free. You don't need an LLC or an S Corp or even a name separate from your own.
Step 2: Make some money. It doesn't have to be much. Ten dollars is fine, but even better if it is enough money that someone gives you a 1099. Babysit someone's kid. Mow your neighbor's lawn. Shovel a driveway. Do an online survey. Whatever. Make some money. Report it on Schedule C (lines 1, 5, 7, and 31) at the end of the year. Don't forget Schedule SE too. Congratulations! You're now self-employed! That wasn't so hard, was it?
Step 3: Open an individual 401(k) at Fidelity or eTrade. You can contribute 20% of your self-employed income if you like (report it on Form 1040), but it's not required.
Step 4: Roll that pesky IRA over to the individual 401(k) before December 31.
Step 5: Do the Backdoor Roth IRA as usual. (Contribute $7,000 to a traditional IRA, then convert it tax-free into a Roth IRA.)
Voila! You can now invest $7,000 a year ($14,000 a year if you do it for your spouse, too) in a tax-free and (probably) asset-protected account instead of your regular old taxable account.
More information here:
How I Failed and Then Mastered the Backdoor Roth IRA
The Backdoor Roth IRA When Life Is in Flux (and Why to Beware a Contribution in January)
What Does the IRS Say About Backdoor Roths?
The IRS didn't really weigh in about the Backdoor Roth IRA for years, leaving taxpayers and advisors wondering if the step transaction doctrine could ever be applied to it. I have yet to hear about a case where the IRS gave someone a problem (other than asking a few clarifying questions) about the Backdoor Roth IRA (please send me details if you know of one), and there has not been a tax court case resolving this issue. But I found out a few years ago that the IRS had at least said something about it, although what it said really didn't surprise me. As noted in this article in Financial Planning:
“Michael Kitces maintains that planners who do them right away, shuttling IRA money into a Roth without a waiting period, run the risk of incurring the IRS' wrath. The IRS guidance on the matter, however, would seem to allay those concerns.
‘There's no caveat about waiting,' the IRS says in an email via its spokesman Dean Patterson . . .
The IRS sent one of Marty McNamara's clients a worrisome letter triggered by a Roth conversion that could have produced an additional tax plus interest and penalties, he says. The client prepares his own tax returns, he adds.
The client's 1099-R forms showed the Roth conversion amount, McNamara says, while another form, Form 5498, showed the IRA contribution amount. Custodians automatically provide both forms to the client and to the IRS. Those two amounts had to match and they did, McNamara said, but the client failed to inform the IRS that he had no other IRAs.
‘After some coaching on my end,' McNamara, a CPA and the cofounder of Marrick Wealth in Irvine, Calif., says, ‘my client was able to respond to the IRS with a letter explaining the nondeductible IRA contribution and subsequent Roth conversion. He also included a copy of the 1099-R and Form 5498, explaining the basis in his IRA was equal to the conversion amount and that he had no other IRA balances, so the conversion was non-taxable. The IRS responded with a letter explaining [that] no further action or taxes [were] required based on the information provided. Of course, we were both pleased with the outcome.'”
Nobody in Congress or the IRS seems to really care. The only question is whether the law will change to allow high earners to make direct Roth contributions or whether the law will change to once again disallow high earners from making Roth conversions.
What do you think? Are you one of the dozens (hundreds?) of people who have had this question at one point? Do you have a pro-rata problem? Can you solve it by starting a (very small) business? Do you worry about the step transaction doctrine?
[This updated post was originally published in 2017.]
Excellent and timely post. I have a 401k from a prior employer that I wanted to roll into an IRA to improve my investment options. Of course, I also want to do the Backdoor Roth and avoid the pro-rata rule. The individual 401k seems to be the critical link to make this happen. Are you able to report income from a business even if you don’t receive a formal 1099? For example, if you are paid in cash, would that count?
Yes.
Hi,
I put in $3500 to Roth IRA in January 2024. Last week, I realized income (married joint filing) will be higher and I decided to do recharacterization. I realized that I have $ 3890.19 (+390.19 gain)in my traditional IRA. I want to make it full $7000 for 2024 in my Traditional IRA before coverting to Roth IRA.
Can I still add another $3500 (which will make $ 7390.19) to convert ? OR I can only add $3110 to make it $7000 total in my traditional IRA before converting to Roth?
If I am converting $7390.19, only $390.19 will be taxable. Rt?
Thank you so much.
I have the same question. I added $7000 to the tradition IRA but it had $5 from last year. I dont know if I can transfer $7005 to the Roth IRA of if I should leave those $5 for next year and add less that time to not exceed the max amount.
Yes, you can convert as much as you want. The limit is on the contribution step. So convert $7005 before year end. You’ll pay taxes on that last $5. No big deal.
Perfect. Thank you for clarifying and taking the time to respond!
I realized last night that I had $0.02 in my IRA accounts after the conversion and was planning on reading today about what to do with it.
Thanks!
Amazingly common question for people doing it for the first time.
Isn’t it wonderful that the White Coat Investor was here to give you his two cents on what to do about your two cents?
Couldn’t resist.
Cheers!
-PoF
That was money!
?
I deposited 38k as a rollover deposit into my sep account my account is showing .02 cents what happened to my money what does that mean . ? Can someone explain what those interest or cents mean and why my money is not reflecting
Your money earned 2 cents of interest. No biggie.
You know a rollover into a SEP-IRA doesn’t prevent the pro-rata issue with the Backdoor Roth IRA process, right?
I don’t know what it is about the Backdoor Roth IRA that triggers this question but you are 100% right. People often freak out about having a few extra cents. For the past two years I’ve been doing my taxes by hand (and then checking the results in Turbotax) and one of the things you’re quick to learn is that the IRS has zero concern about your cents. You just round up or down and keep moving.
Kind of a side question but I’ve been wondering about this – doing taxes by hand and checking on TurboTax. Currently I just use TurboTax, have you found any big discrepancies?
HR Block software screwed up my 8606 this year and it took way more effort than it should have to fix it.
Definitely worth it to double check the software – generated forms.
Just FYI I opened an individual 401k at schwab for the same purpose and it was great. Easy to open and they also take rollovers.
Well that’s interesting. The last time I looked at that issue they didn’t take rollovers. Vanguard is starting to look pretty lame on that issue. Hope they change soon. (And hope they start offering Admiral shares!)
No kidding. Last time I rolled over in Vanguard required a schwab account. I moved to them, did the rollover and then moved back to Vanguard. What a pain in the buttocks that was. Not having admiral shares is also crummy. I sometimes consider moving that money out to fidelity to keep costs lower.
My +1 was to Nate. Schwab made whole process super simple.
+1
Are there any restrictions to the self employment? E.g. if I have rental properties can I count that? I have a couple of properties and a fat traditional IRA that has so far scared me away from a backdoor Roth.
Unfortunately, no. Income from rental properties is classified as passive income and not earned income. You need earned income to open a business and create a solo 410k, etc.
Then go mow some lawns in the summer. Earn over $600 and file a 1099. Apply for an EIN and viola, you’re self employed. Open a solo 401k and put your $600 there. You don’t even have to contribute to the solo401k anymore, just use it as a vehicle to accept rollovers from your traditional IRA prior to performing a backdoor Roth conversion each year.
I’ve been applying the common sense doctrine and ignoring the pennies for years, glad to know I was right.
Not that it matters, but for the Vanguard users out there who convert a day or two after making the tIRA contribution, just give it s few weeks and the stray cents from the money market dividend will auto sweep into the Roth.
Hmmm…it hasn’t done that yet for me after about 6 weeks. I’ve still got 7 cents sitting there in mine. But my wife’s has nothing. I think the difference is I put mine in the sweep account (Federal MMMF) and it was there 2 days. Hers went into Prime MMF for just a day, which isn’t technically the sweep account, and then the 11 cents automatically followed into the Roth RIA. Next year I’ll put mine in Prime MMF. Way easier.
IRS instructions for line 10 of Form 8606 are to round to 3 decimal places. 5500/5501 rounds to 1 (0.9998). Need to convert at least 5503 to round to 0.999 and owe any tax. Or am I missing something?
Interesting. You could save almost a dollar in tax with that trick!
Sounds similar to the people who (not sure if they are still able to) keep a balance of usually <$1.00 on credit cards so that the credit card company waives the entire "balance" thereby earning someone like $12 a year per card 😛 People would make a payment right before the statement ends to get the balance down.
does it not mess up line 14 then? because line 14 becomes negative??
Just leaving for future reference, since I had the same question: line 14 is a basis, and cannot be negative
I think your math in the example is off though. Line 11 is .999*5501 = 5495.499 you have 5500 Im also not sure why you used .999 since the instructions say round atleast 3 decimal places wouldnt that mean 1? I just think using 1 dollar is too small of an example? Can you redo with larger number like $5 so we can see the math play out? Thanks!
You seem capable of doing the math yourself so I’m not sure I’m any better of a mathematician than you. Keep in mind when I wrote this article interest rates were so low most people were asking this question about pennies, not dollars.
Its more im not confident I know where to put the gain….
Okay, let’s do an 8606 with a $7008 conversion.
1 7000
2. 0
3 7000
4 0
5 7000
6 0
7 0
8 7008
9 7008
10 0.999
11 7001
12 0
13 7001
14 0
15a 0
15b 0
15c 0
16 7008
17 7001
18 7
How’s that look?
When I follow your math for conversion of $7008, I get the line 14 as -1 because its 7000 (line 3)-7001 (line 13). When we have negative number for line 14, does it always turn into 0?
The same thing happened to me. line 1 – $7000 line 2: $6500 line 3: 16500. My scenario is similar. I had $2.60 in my tIRA on 12/31/24 reported on line 6. I converted a total of 13,501.92 (2023 and 2024’s coversion both happened in 2024). Adding line 6,7,8 gets 13504.52. line 11 ends up at 13,500.47. Then line 14 calculates at 13,500 – 13,500.47 giving me a negative number.
Most tax forms you can round to the nearest dollar.
Line 14 can definitely be negative. Just carry it forward to the next year.
another stupid question as I’m doing my paper taxes for the first time. What do we do if it’s a positive number. what does “just carry it over to the next year” even mean haha. I’m wincing.
I means it goes from line 14 this year to line 2 next year.
Hi, I got a negative number ($-5) for line 14 as well. When you say
it goes from line 14 this year to line 2 next year,” does this mean that I will be reporting $-5 for line 2 for next year? Thank you!
Yes.
I did a Backdoor Roth for the first time in 2016, followed the 3 steps, and had the 0.68 left over after conversion like you’re talking about. I didn’t know what to do with it, so I did another Backdoor Roth already this year, but only converted $5,500 again this year. So the (now) 0.86 is still sitting there.
What do I do for 2016? Contributed $5,500 and converted $5,500 with $1 left over. Pay taxes on $1? Or not since it was not converted?
So my basis for 2017 will be $1, contributed $5,500 and converted $5,500 with $1 left over again. How do I deal with that for 2017’s taxes?
Sorry for the small variation question on this post, couldn’t find this situation in the comments of the previous post.
Wow! You read 1000 comments? I’m impressed. At any rate, you’ll probably owe tax on $1 in 2016 once you work through the 8606. But maybe not. Maybe it just rounds out as someone noted you’re only supposed to round to 3 figures on line 10.
Thank you for the great post Jim!
I’m also in the same boat as Mike. I contributed $5500 to my traditional IRA but then accrued $0.56 prior to the conversion. I converted only $5,500 to my Roth IRA as part of the Backdoor. Now I have $0.56 sitting in my traditional IRA account.
It shouldn’t matter if it’s still in there right? I’m planning to contribute $5,499.44 in 2017 and then convert it to Roth IRA. It essence this will equal to $5,500. Will this be ok?
No. Contribute $5,500 next year. Then covnert $5,500.56.
I saw your ‘pennies’ post regarding how to report the taxes with the leftover money in the traditional IRA account. Is there a way to do it on turbo tax or will this have to be done manually by the accountant? Thank you
Nah, easy to do on Turbotax. Just convert the last few pennies or dollars in a second conversion and then total it up for the conversion amount.
I get accounting for the taxation on the ‘pennies’/$1 on the form 8606 for the interest that was accrued but isn’t there a penalty from the IRS for contributing over the limit (besides just the tax)?
Yes. You can’t contribute more than the limit to the traditional IRA initially. But growth in there prior to conversion is not penalized, just taxed upon conversion.
Clarifying question – if it is only taxed upon conversion, looking back to the original article and the $6 Q&A (pasted below for quick reference), why would you pay $2 in taxes this year versus the following year when it’s converted?
//
Q.
But now it’s 2023 and money market funds actually pay interest. So now there is $5.65 still in the traditional IRA!
A.
Great. Same choices. Convert it to the Roth IRA (and owe a couple of bucks in tax on it) or leave it there, get pro-rated this year (paying two dollars in tax on that $6) and clean it up on the 8606 next year (where that $6 will be converted tax-free along with your next $6,500 that you contribute for next year.)
The tax would be due in the year it is converted.
I did the backdoor roth IRA in 2021, and 2023 poorly. I followed the steps correctly, but made $ in trad and then converted it all (with earnings) to roth. I have never filled out the 8606 so I’m playing catch up. With this error, will I also need to file the amended 1040? Please help with the numbers and how to proceed. In 2021, I contributed 6k, but it grew to 6008 and I converted it all, this makes line 14 a negative number 6008*.999=6001.99. 6k-6001.99= -1.99. Do I really use a negative number on this form? For 2023, contributed 6500, which grew to 6505 converted*.999=6499.49 so line 14 is +0.51. Please help.
I’ve never seen definitive info on whether a 1040X has to accompany an 8606. I’d send one. It’s easy to do. When I’ve done them I’ve just done them by hand.
Line 14 shouldn’t be negative. You shouldn’t have basis. Line 18 ought to be $8. Line 14 should be a zero. Did you mess up the math? I bet rounding off 0.999 to 1.000 fixes everything. What’s that fourth digit?
I didn’t rollover my traditional IRA to my work 401k until this month. So in 2016 I still had money in the tIRA. Can I still do the backdoor Roth for 2016 or would the pro rata rule apply? Thanks!
When did you do the conversion step? If in 2017 this is going to work out just fine. You just have to fill out the 8606 a little differently.
https://www.whitecoatinvestor.com/late-contributions-to-the-backdoor-roth-ira/
If you did the conversion last year, you’ve got a hassle on your hands.
“You’ve got a hassle on your hands.”
This is my personal worry. I procrastinated in both learning about backdoor Roths, and asked my custodian of my tIRA to clear it out and send me a check so I could roll it over into my 401k from work. (they couldn’t send a check directly to 401k custodian). I requested this around Dec. 20th. I contributed 5.5k to vanguard IRA and converted to Roth the next day….. turns out, my tIRA wasn’t cleared out until Jan 13th. Crapola.
I’m in the exact same boat. Contribution to tIRA was in 2016, but not rolled over into Roth until 2017. How does that affect the 8606? Ive been reading the post about the late backdoor contributions, but I’m not sure that applies because the way the 8606 is filled out implies both the contribution and conversion occurred in 2017 for the 2016 tax year, noir straddles across two years. Thanks in advance! That backdoor Roth post has helped countless people.
A little bit different scenario….. from what I understand is that you can contribute to tIRA and convert until April 2017 for your 2016 taxes.
My issue is that I had a tIRA balance on December 31 2016….. and from what I know thats a problem
I’m sorry guys. I try to be very clear when writing or speaking about this that you must empty that IRA out by December 31st of the year you do the conversion. If you can’t empty it out, it’s better NOT to do the conversion until the next year.
The problem now isn’t so much that you get “pro-rata-ed” on the 2016 conversion. You could fix that in 2017 just by filling out the 8606 right. The problem is you got a pro-rata-ed conversion, then rolled some after-tax money into a 401(k) and told them it was pre-tax money.
The easiest thing to do may be to reverse the rollover and conversion and start over if you can.
Oh, you’re very clear in your posts, Jim…… Its my fault because I’m stupid.
I haven’t actually rolled the money over to 401k yet, I still have the check in my hands. So maybe I got lucky and can just put it back into the tIRA, find out with the help of CPA what is pro-rata-ed and go from there. I had the pleasure of finding out that financial services grind to a halt during the holidays.
Oh, that’s probably good news. You need to get it back in there within 60 days though. You do NOT want that check in your hand 60 days from the time it was cut.
I must have mis-read. I have a different problem. There is no pretax money in my case. It’s all for the purpose of the backdoor. My only issue is the contribution was in 2016, but I didn’t rollover to Roth until 2017. I’ve read the post on the late contribution, but that 8606 example is for if both the contribution and conversion were both late in 2017 for the 2016 tax year. Just wondering how I’d fill out the 8606 differently. Thanks for all you do!!
Good for you. You’re not in the crappy situation Will is. Doing the contribution in 2016 and the conversion in 2017 is not a big deal. The contribution step goes on the 8606 for 2016 and the conversion step goes on the 8606 for 2017 (along with the contribution and conversion for 2017.)
Maybe I should do a post on all the ways to screw up a backdoor Roth IRA and how to fix them.
that would be an awesome post! It’s quite a simple concept, but with all the IRS form complexities, there are so many ways to screw it up.
As I stare at the 8606 more, I think I understand it now. Thanks for the reply!
Can you show an example of how this would look on the 8606. I also now made 4 bucks (should have done it the day after but residency got busy), but I do understand where that goes on the form. I am more confused about the tIRA basis part, as like above it will have been a non deferred ira that i contributed to in 2016 along with this 2017 contribution and conversion. And I realize these conversions will all go on my 2017 tax form. As I just did the conversion I just want to make sure I did not mess it up.
While I did not read through all 1000 posts I read through a few hundred and that is how I found this guy in my same situation.
Also I was at my specialties national conference in SD, and the locumtenems group was talking about how they had you come talk at the EM and Ortho event they did. You should do that for all the specialties! (In short I would come to any event you host for teaching if I was in the area).
Post is referencing: “Good for you. You’re not in the crappy situation Will is. Doing the contribution in 2016 and the conversion in 2017 is not a big deal. The contribution step goes on the 8606 for 2016 and the conversion step goes on the 8606 for 2017 (along with the contribution and conversion for 2017.)”
I’m not exactly clear on your situation or what you’re asking. I think you’re asking about the situation that this post addresses:
https://www.whitecoatinvestor.com/late-contributions-to-the-backdoor-roth-ira/
I rolled over my tIRA to 401k in January 2017 to avoid pro rata rule. I have yet to do the backdoor Roth conversion but was going to do it very soon. Can/should I still do backdoor for 2016 or should it just be for 2017? Thank you
You can still do 2016. You just need to make sure the tax-deferred money is not in an IRA on Dec 31st of the year you do the conversion. If you do the 2016 conversion in 2017, you have until Dec 31 2017.
Interesting. So I just have to have my tIRA empty before Dec 31, and then can to the back door contribution anytime in 2018? Along with my 2018 contribution? So empty this year, contribute x 2 next year ( $11k), right?
Actually, if you don’t contribute until 2018, it doesn’t matter what your balance is on 12/31/2017. Work your way through the 8606 and you’ll see why.
Very timely post – was working on this today!
I would recommend checking out the very detailed step-by-step guides for “How to Report Backdoor Roth” at “The Finance Buff” blog for those who use DIY tax software (there for H&R Block, TaxAct, and Turbotax) with really fantastic instructions and screenshots. I was having trouble inputting my info to make it match the example 8606 above before finding the guide.
(I have no financial interest in the finance buff, just found it a really helpful guide!)
I was going to do a post on that once, but couldn’t think of a single way to improve on his post, so I just linked to it in my tutorial post.
How much of a hassle is the 5500 form filing if you have IRA assets to rollover more than $250k? Any increased risk of audit or anything like that? Need a TPA?
I don’t know that there is more audit risk. You do have to do a 5500, but my understanding is that for a solo 401(k), you can do a 5500EZ which looks awfully easy. https://www.irs.gov/pub/irs-pdf/f5500ez.pdf
I don’t think you need a TPA, but you might need a CPA to help you fill it out.
Yeah that happened to me before. I just left the few cents in the traditional IRA until the following year. It didn’t go up by much.
First off thanks for the heads up on the back door Roth combined with self employment. One more interesting fact I recently determined. My wife became a stay at home mom his year. I thought this meant I couldn’t contribute to her Roth. However there is an exception for a non working spouse. As such I don’t have to do some complicated backdoor transaction to get her yearly contribution.
Why don’t you? I think you’re misunderstanding the rules. A spousal Roth IRA for a high earner also needs to go through the backdoor. It would be nice if I was wrong, but I don’t think I am.
See IRS publication https://www.irs.gov/publications/p590a/ch02.html
See Kay bailey Hutchinson spousal Ira limit:
For 2016, if you file a joint return and your taxable compensation is less than that of your spouse, the most that can be contributed for the year to your IRA is the smaller of the following two amounts:
$5,500 ($6,500 if you are age 50 or older), or
The total compensation includible in the gross income of both you and your spouse for the year, reduced by the following two amounts.
Your spouse’s IRA contribution for the year to a traditional IRA.
Any contributions for the year to a Roth IRA on behalf of your spouse.
This means that the total combined contributions that can be made for the year to your IRA and your spouse’s IRA can be as much as $11,000 ($12,000 if only one of you is age 50 or older or $13,000 if both of you are age 50 or older).
Limits on Ira usage based on being below the cutoff still apply.
There is no limit on contribution. Only on deduction.
Okay I agree with all that. I’m missing your point.
My wife for the first year of our marriage has no income. I’m still under the Roth IRA income AGI thanks. I had thought since she did not work I could not contribute to her Roth IRA, since she has no income, unless I did a conversion. I recently learned I was wrong. I guess it depends on the definition of high earner as this applies to someone under about 230k a year depending on the sophistication regarding taxes and sources of income.
whats your opinion on non deductible ira’s?
Sometimes better than a taxable account, but often not and often not by much. What’s the point of a non-deductible IRA when you could have a Roth IRA? The Roth IRA is clearly better.
Is it even necessary to report our non-deductible Traditional IRA contributions? If we don’t owe taxes on it, does the IRS even care that we made a contribution to a Traditional IRA and then later converted it to a ROTH?
Yes. That’s the whole point of the 8606. So you and the IRS know your basis in a non-deductible IRA going forward.
you have to file if you make non deductible ira form 8606
Hi Jim,
What about switching from self-employed SEP to Solo 401k (i.e. Opening a new ira) and rolling over the old SEP balance? Are there any issues with switching retirement account types for the same business?
Thanks in advance!
Sorry, didn’t mean IRA- just different plan…
No. I wouldn’t contribute to both for the same year though.
Do you suggest turbotax users pay for the audit representation insurance? Is it expensive to get representation after the fact? I’m sure this depends heavily on the person’s circumstances, but let’s say it’s a hospital employed physician with IRA, HSA, and backdoor Roth contributions, also a homeowner/itemizer… aka me!
I’m not sure you need representation in most instances. Most audits they’re just asking some questions and for some additional documentation. Now if the IRS came up and said you owed another $200K, it might be worth hiring representation.
Jim, first off, thanks so much for this site. Last year, I did this process for the first time, but now realize I may have an issue. Before starting the process, I had a Rollover IRA and needed to sell all of the shares in it and roll the money back into my 401(k). I did that. Then, in early April 2016, I opened a new traditional IRA account and contributed $5500 for the tax year 2015 and my spouse opened a new traditional account and also contributed $5500 for 2015. In late May, we converted both traditional IRAs into Roth IRAs. We’re now looking to contribute $11,000 for tax year 2016 and another $11,000 for tax year 2017.
Here’s the issue. I’ve discovered there is still $60 in my Rollover IRA. Based on the transaction history, it looks like I received a $60 dividend from the company just days after I sold all the shares in my Rollover IRA and rolled the money into my 401(k). So the $60 was in my Rollover IRA when I converted the accounts (and it’s still in there). Does this cause problems for the conversion that I did last year? Does this affect my spouse’s accounts or just mine? And how can I best address this issue so that I can make the contributions for 2016 and 2017?
Not really. You just document it on the 8606 for tax year 2016. And fix it this year by rolling it over with your 2016 and 2017 contributions.
Just yours.
You can still do contributions just fine. You just got pro-rataed for your 2015 Backdoor Roth IRA (converted in 2016). That’ll be demonstrated on the 2016 8606.
But now you know why I recommend you do the 2016 contribution and the 2016 conversion in 2016. Easier paperwork.
Thanks so much. Really appreciate it. Just following up on the $60 remaining in my Rollover IRA and what you mean by “rolling it over” with my 2016 and 2017 contributions. Do I need to roll that $60 back into my work 401(k) before converting my 2016/2017 contributions from my traditional IRA to the Roth IRA? (Speaking of paperwork, I would love to avoid having to do this because my Rollover IRA and my work 401(k) are with two different institutions, so it is a bit of a paperwork hassle.) Or is this $60 no longer considered pre-tax money because it got pro-rataed, such that I can just convert it into my Roth IRA?
Yes. You can convert it. Since it was pro-rated, part of that conversion will be taxable (a very small part) just like part of your conversion last year (a very small part like $58) is taxable.
Understood. What if I decided to go through the hassle and roll that $60 back into my 401(k) to save the taxes on it? Could I still do it? Is it still considered pre-tax money? Thanks again!
Part is pre-tax and part is post tax. With tiny amounts, it is often simplest just to convert them and pay any tax due.
Does a Simple IRA count toward the pro rata rule with respect to backdoor Roth conversions? I was under the assumption it wasn’t (pretty sure my accountant said it wasn’t when I asked him a couple years ago), but after reading this blog it’s sounding like it actually is. Which would really suck obviously.
I did a mega roth conversion a couple years ago with our traditional IRAs, but my wife (with her employer’s contribution) have been maxing out her Simple IRA since starting her job a couple years ago.
Yes. It does. I’m sorry. If your accountant told you that, he was wrong. Read line 6 of Form 8606. It says:
“Enter the value of all your traditional, SEP, and SIMPLE IRAs.”
Well that’s pretty sucky.
Am I correct in assuming that if i’m in the population of people that contributes to a taxable account (after contributing to all my available tax advantaged accounts) that it is still advantageous to continue with these doing backdoor Roths despite the pro rata?
Also, is it possible for me to do this “business 401k rollover” you describe if the Simple IRA is still openly receiving contributions?
No, probably not. I’m sorry.
If you thought this job situation or this retirement plan situation was only going to last a few years you could contribute to a non-deductible IRA each year with a plan to convert it all eventually.
Do you have any prior posts helping decide whether or not not to do the conversion with an unavoidable pro-rata situation?
Right now we have around 50k in the Simple IRA and are contributing 11k as a backdoor Roth between the both of us this year. (Puts us to around 85k in our total Roths) Just wondering if there is a threshold to start putting that $ into taxable account instead.
I think you’re missing something fundamental. The point of a backdoor Roth IRA is to put money that would be in taxable into a Roth IRA, not to convert tax-deferred money to a Roth IRA. The first is a no-brainer, the second requires some careful calculations and assumptions and even then may turn out to be the wrong move.
Now if you don’t think you’ll be using a SIMPLE IRA for long, then sure, contribute to a non-deductible IRA for a few years. When you sort out the SIMPLE issue (by rolling it into a 401(k), then you can convert your non-deductible IRA with 4 or 5 years of contributions in it to a Roth IRA. You’ll only pay taxes on the gains when you convert so most of it will still go into a Roth IRA tax-free.
But doing the conversion step with a $50K SIMPLE out there? What’s the point? It’s not much of a backdoor Roth since you are paying taxes on almost the entire conversion.
The alternative, if you’re not still contributing to the SIMPLE, is to convert the whole thing to a Roth, then do your backdoor Roth conversion step. But that’s going to cost you some tax money.
I just filled in a hypothetical 8606 for 2016 and now realizing how much this sucks. Is there any way to reverse my contributions to the backdoor Roths for both 2016 and 2017 (I already converted my 2017)? I imagine i’d have to pay taxes on any gains, just wondering if there are additional penalties I’d have to pay.
Pretty irritated my accountant didn’t know about this….. 🙁
Yes, you should still be able to recharacterize both of them to a traditional IRA. That’s no big deal. You can then just leave it in a non-deductible IRA and invest it, or you should still be able to reverse the contribution itself, paying taxes only on the gains. More details on that here: https://finance.zacks.com/can-ira-contributions-reversed-same-year-2098.html
Thanks WCI 🙂
Why do you say “this doesn’t work so well if you have a business where each year you are making SIMPLE or SEP contributions”? Either this is not true, or I am am a moron and violating tax law.
You can make your SEP contributions throughout the year, move it into your 401K by say December 1, and then do the backdoor roth through a traditional IRA before December 31. That way on December 31 your basis in IRAs is zero, which is the amount reported on form 8606, making the backdoor roth not taxable.
Your advice in the post immediately above about rolling the SIMPLE into 401K misses one important caveat. You must wait two years AFTER making your final contributions into the SIMPLE to move the money out (whether this be to a 401K to reduce your IRA basis to zero to do backdoor Roths in future years, or to do a mega Roth conversion from the SIMPLE plus any contributions to nondeductible IRAs). If you don’t wait for two years there is a whopping 25% penalty on the value of the SIMPLE! (form 5329, part 1, line 4).
Many of my friends start out with a SIMPLE when their practice is small/ growing/ not earning much and then switch to a 401K (multiple employees would make the higher SEP IRA matching non-worthwhile). I advise them to continue to contribute to their nondeductible traditional IRA, after the two years is up they move the SIMPLE money to a 401K and then the nondeductible traditional money into a Roth- same advice as posted above.
Here’s a link to the IRS table showing the above is true: https://www.irs.gov/pub/irs-tege/rollover_chart.pdf
Finally, there are ways to do this besides opening up a solo 401K. If your previous employer allows rollovers from other plans, such as self employment plans, you can take advantage of this to reduce your IRA basis to zero every December 31. I am a solo practice ophthalmologist (single employee excluded from SEP matching until 2018 because she started to work the year after I did) and max out my SEP. I then move the money into my former mega health system’s Fidelity 401k (which has a SP 500 fund with expense ratio of 0.01%) and then do a backdoor roth with vanguard.
Additionally, you advocate putting IRA money into a solo 401K. I respectfully disagree; the advantage of using a group 401K plan (either a current one or one from a previous employer that still is open) rather than your solo 401K is because for asset protection purposes a group 401K is more ironclad; there has been case law that solo 401Ks are not ERISA plans because they only benefit one individual (or married couple), so therefore sometimes you have to declare bankruptcy to get the asset protection, depending on the state you live in:
https://www.irafinancialgroup.com/solo401kassetprotection.php
Of course, not every group 401K will accept rollovers from outside plans, and you’d have to weigh whether the expense fees of the investments are (if they are high or have limited selection) vs the value of higher asset protection.
And just like WCI I get these questions answered all the time (for another thread I give financial advice for) so this a cut and paste stock answer…
Obviously it’s fine to use the SEP throughout the year as long as you clean it out by the end of the year. But if you’re using a SEP, you might as well use a 401(k) most of the time. The 2 year SIMPLE issue is yet another reason why a SIMPLE stinks.
“If you’re using a SEP, you might as well use a 401k most of the time”…. really? I guess “most” doesn’t mean always. If you have one or two employees in your practice and they turn over every three years (which happens a lot), then you don’t have to match them. I have a friend whose only employee in her solo practice is her bookkeeper, for which she pays maybe $500 a month and wouldn’t be painful to match. Three other employees have worked for her for under three years, so she can use the three year test for matching. And I know plenty of other people in this situation. Contrast this to a 401K where you either have to pay a 0.5% AUM fee (Merrill for example) or a $3600 annual fee (Vanguard) or some type of a combination, as well as provide a 2-3% match for all employees after a year. But if you have many (or even one) employee that you’d have to match with a SEP then a 401K might make more sense- but I’d run the numbers before making any blanket statements. IMO in many instances a SEP makes more sense than a 401K.
I see both points. I suppose the problem would arise if/when you wish to contribute to a Roth IRA via the backdoor. The SEP would then have to be cleared into a 401k prior to the conversion. Otherwise you’ll get “pro-rata’ed.” If a Roth is something you’re not interested, then going straight SEP may be advantageous.
That comment refers to an independent contractor without employees. Once you have employees, it’s time to get professional help with your retirement plan. Sometimes a SEP makes sense, sometimes a 401(k) makes sense, sometimes a SIMPLE makes sense and sometimes nothing makes sense. Much more complicated. If you’re an independent contractor, a solo 401(k) is better unless you forgot to open it before Dec 31 or if you’re afraid of a couple more pages of paperwork.
I contributed 5.5k to a tIRA with 23k in it with initial contribution yrs ago pretax of 5.5k I.e with about 17.5k of gains in 2016 and converted the entire sum to Roth fully understanding that I will be taxed on the 23k. Hope I did not screw up. Just wanted some tax diversification.
That’s a Roth conversion, not a backdoor Roth, but also can be useful and will certainly give you some tax diversification.
Your solo 401(k) to receive the tIRA is interesting — I stumbled across this purely by accident, but not long after posting the Solo 401(k) idea on Bogleheads for discussion (see https://www.bogleheads.org/forum/viewtopic.php?f=2&t=209961.)
Several folks there seem to think it’s pretty close to the line, if not entirely across it, and there’s also some debate as to whether it’s legitimate to continue a Solo 401(k) if you don’t have ongoing economic activity.
I don’t write the rules. Talk to Congress. But the way the rules are written, a business making money is enough to open a 401(k). And continue one? Give me a break. Why wouldn’t you be able to continue one?
I tend to agree with you, but there are some very vehement folks over there that are arguing that a 401(k) is only operated by a business, and if the business is dormant, the 401(k) must be dissolved.
Define “dormant.” Just because a business has no profit one year certainly doesn’t mean it isn’t in business.
Ha — that was exactly my argument here (https://www.bogleheads.org/forum/viewtopic.php?f=2&t=209961&p=3236055#p3221383).
If you take the other position, it leads to the outcome I described as “perverse”: that the plan would have to be shut down as soon as the SE person retired. (Describing the tax code as perverse is nothing new, of course. Also, when does a consultant really retire? I haven’t done any SE work in several years — but I might tomorrow, given an attractive opportunity.)
That is, however, exactly the position taken by a couple of contributors on that thread, as well as here: https://www.pgiselfdirected.com/2014/04/17/terminating-your-solo-401k-plan-irs-requirements/