The biggest mistake with a backdoor Roth is not telling your tax preparer that you did one. With most tax matters, you can simply hand your preparer your IRS reporting and accounting records and be done with it. However, the IRS reports you have before the filing deadline are not enough to make sense of what has happened. Telling your tax preparer that you have done a backdoor Roth is the most important step of the strategy. We help our clients avoid this mistake by sending them a reminder with the necessary information at tax time.
The second biggest mistake with a backdoor Roth is that your tax preparer doesn’t file it correctly.
I am a tax specialist for Marotta and currently perform tax reviews for our clients. As part of that service, I review their tax returns for obvious mistakes made by their tax preparer. In 2019, 14.29% of the backdoor Roth contributions our clients completed were misfiled in some way by their tax preparers and required amending.
Luckily for our clients, we often catch these mistakes and help their preparer navigate the amendment. Unfortunately, it is a frustrating set of extra work to amend a tax return.
As a result, I have written this article for the tax preparers of the world in the hopes that we can get backdoor Roth filings right the first time this year. Once you know how to file it, it is a simple and easy process.
First, what is a nondeductible contribution?
Your ability to contribute to a Roth IRA or receive a deduction for traditional IRA contributions is restricted as your income goes beyond a certain threshold. However regardless of your income level, you are still allowed to make a nondeductible contribution to your traditional IRA. If you file correctly, this contribution is put into your pre-tax account after taxes. That after-tax portion becomes a so-called nondeductible basis and is tracked as a part of the IRA until the account is emptied.
Rather than tracking the precise dollars as nondeductible IRA dollars, the IRS requires that you blend all your IRAs together. Thus, when you have a nondeductible basis each distribution or conversion is taxed pro-rata after-tax and pre-tax based on the size of your IRAs and the size of your nondeductible basis.
Second, what is a backdoor Roth?
If you have no IRA balance, you can make a nondeductible contribution and then convert that contribution to Roth IRA and 100% of your Roth conversion will be after-tax and thus not taxable. In this way, if your have no other IRA money, a backdoor Roth is equivalent on your tax bill to funding your Roth IRA directly in the first place.
In order to accomplish a backdoor Roth or nondeductible contribution, there are a few tax forms you need to report correctly.
Report the strategy on Form 8606.
Nondeductible contribution and backdoor Roth filings start on Form 8606. Part I reports your contribution as nondeductible and Part II figures the tax on your Roth conversion. Here are the common mistakes:
You need to fill out one Form 8606 per individual. So for joint filers, that means one for each spouse that utilized the strategy.
Fill out Part I. The form says you need to fill out Part I if “You made nondeductible contributions to a traditional IRA for 2019.” The client did, so you need to fill it out.
You need to fill out all of Part I in order to get the correct answer. If you skip even one line, you may get the answer wrong.
Of note, you can contribute a prior year nondeductible contribution after December 31 of the tax year but before the filing deadline. If the client does this, the corresponding Roth conversion of those prior year contributions is still a current year Roth conversion. In this way, a client may tell you, “I did a 2019 backdoor Roth in March 2020,” but you will only be able to report on Line 1 and 4 that they made the nondeductible contribution. Next year, you will need to file a Form 8606 again to handle the 2020 Roth conversion of those 2019 nondeductible contributions.
Many tax preparers get stuck on Line 6 which asks for the total value of all your IRAs as of December 31st of the year prior. For some reason, getting stuck here makes them take shortcuts on the form. If the client has done a true clean backdoor Roth strategy, then this answer is likely $0. If they are merely making nondeductible contributions, then they may have a traditional IRA balance already and you will need to ask for it. Failing to get an accurate number for Line 6 means you will get the wrong answer. If you are preparing this form for one of our clients ask your client for the IRA Summary Report we generate for them. This will have most of the numbers you need.
Line 7 and 8 are where you put the numbers from the client’s 1099-Rs as these lines ask for IRA distributions and Roth conversions respectively.
Line 9 then adds the previous three together to create a reconstituted IRA value as of December 31st of the tax year. This is then used as the divisor in Line 10 to calculate what percentage of the tax year’s IRA was nondeductible.
Of note, even in a true clean backdoor Roth, you may find that the total on Line 9 is larger than the total nondeductible basis available on December 31 on line 5. If for example a client contributes $7,000 nondeductible to their IRA but their 1099-R says they converted $7,001. In this scenario, you’ll get 0.9998571632623911 on the calculator for Line 10. Fortunately, you are instructed to report the number as “a decimal rounded to at least 3 places.” That would make Line 10 still equal 1.000 (as 0.9998 rounds up), but if the assets sit for longer or earn more, you may find that a few dollars are taxable.
You need to keep track of the client’s nondeductible basis from year to year. Line 2 of this year’s Form 8606 should be equal to Line 14 (“This is your total basis in traditional IRAs for 20XX and earlier years.”) from the year before. If the client engages in prior year contributions (those after December 31 and before the filing deadline), then each year they will have last year’s nondeductible contribution on Line 2 and this year’s carrying forward on Line 14.
After filling out Part I, then fill out Part II. Part II is easy to get correct if you filled out Part I, but you can easily make mistakes if you decide to skip Part I. I recommend filling out Part I because if you do, in Part II, you can simply copy down numbers from Part 1 and be done with it.
Put the right numbers on the 1040.
Form 8606 Part I line 15c is the taxable amount of any IRA distributions. In a backdoor Roth strategy, there are no distributions, so if you have a number here, make sure you did your math right and the client actually did make distributions.
Form 8606 Part II line 18 is the taxable amount of the Roth conversion. If they have done a true clean backdoor Roth, this number will likely be less than $2 and likely $0. If they are making nondeductible contributions while also converting, then it will be simply a portion of the conversion that is taxable.
After verifying these amounts, sum them and include on the appropriate line on the 1040 (currently line 4b). Because of the nondeductible basis, Line 4a (Total IRA Distributions) should be larger than Line 4b (Taxable IRA Distributions).
You likely don’t need other forms.
Some preparers are tempted to add in Form 5329 to report additional taxes. However, if the client has done a backdoor Roth this is almost always the wrong form to add.
Yes, they are over the Roth IRA limits, but they did not make excess contributions to their Roth. They converted IRA to Roth. We talk about backdoor Roths like they are Roth contributions, but they are actually nondeductible contributions followed by Roth conversions. So long as they stayed under the IRA contribution limits, they did not make an excess contribution by making a nondeductible one.
Yes, they did distribute from their traditional IRA and they may be younger than 59 1/2, but their IRA distribution was a Roth conversion. Roth conversions are not early distributions. You can convert traditional to Roth IRA at any age.
If after reading this guide you still aren’t sure if you are doing the backdoor Roth filing correctly, reach out for help. I’d like this article to prevent our clients from having to amend their tax returns because of backdoor Roth strategies, and if it is not clear enough for you, then it is not clear enough.
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