The Bogleheads forum regularly receives posts from individuals who have made expensive mistakes with their backdoor Roth. Be sure to read and understand this entire article including proper IRS documentation before you use the process. There will be significant clean up effort with the IRS if the process is done incorrectly and it may be costly.
If you cannot contribute to a Roth IRA because your income exceeds the income eligibility limit, you can still choose to contribute indirectly through a two step process known informally as the backdoor Roth.
If you have already made a Roth contribution but now realize your income is too high, the IRA recharacterization process allows you to treat that contribution as if it were made to a traditional account instead.
Shown in the figure below, you do the backdoor Roth as follows:
- Make a nondeductible (i.e. taxed and not deducted) contribution to a traditional IRA.
- Then convert the traditional IRA to a Roth IRA.
The net effect of performing these two steps is equivalent to contributing to a Roth IRA. Since there are no income limits for either of these steps, you can use this backdoor Roth technique to effectively contribute to a Roth IRA regardless of how high your income is. You just need to have compensation in the tax year for which you will be contributing. For contributions before 2020, you must also have been under age 70-1/2 at the end of the year.
Note that there is no such IRA called a "backdoor Roth IRA", because the backdoor Roth is a process or technique, not an account. Also note that the IRS does not recognize a "nondeductible traditional IRA", because it is the contributions that are nondeductible (i.e. not deducted), not the IRA. There is also a process called mega-backdoor Roth that is completely different than the backdoor Roth and they are independent of each other. Also note that the IRS doesn't officially recognize the term "backdoor Roth", thus some tax preparers aren't familiar with it either. The term is just a shortcut phrase that investors use. So if you come across someone who has never heard of it, just use the terms "contribute" and "convert" instead, because that's what is really happening.
Before proceeding with a backdoor Roth, consider that it is much easier to contribute directly to a Roth IRA if you are eligible to do so.
First, there are three terms which need to be understood when doing backdoor Roths:
- Taxable compensation
- is defined by the IRS as taxable wages, salaries, commissions, self-employment income, alimony and separate maintenance (nontaxable combat pay is also applicable for an IRA contribution). It doesn't include earnings and profits from property, interest and dividend income, pension or annuity income, deferred compensation, income from certain partnerships, or any amounts (other than combat pay) you exclude from income.
- Traditional IRA
- as used on this page, refers to each of a person's non-Roth IRAs, that are also not inherited IRAs. These include traditional IRAs, rollover IRAs (also known as conduit IRAs), SEP-IRAs, and SIMPLE IRAs, including those held at different custodians. The total year-end value of ALL of these accounts will be taken into account when calculating taxes for a backdoor Roth.
- Basis (or cost basis)
- is the total amount of nondeductible contributions in your traditional IRAs. It is a fixed dollar amount and does not grow as the account value grows. It stays steady until one of the following occurs: 1) another nondeductible contribution is added (the basis increases), 2) a rollover of an after-tax 401K contribution is made to a traditional or rollover IRA (the basis increases), 3) a Roth conversion or withdrawal from the account removes some/all of it (the basis decreases).
- The basis also is not associated with any particular account. Rather, it is an accounting device that the taxpayer needs to report to the IRS each year it changes. The increase or decrease in basis is reported using IRS Form 8606.
- IRS Pub. 590-A refers to this as "cost basis". This is the same word, but has a slightly differently meaning than the cost basis used when calculating capital gains.
When you do a backdoor Roth, you first make a nondeductible contribution (i.e., already taxed) to a traditional IRA. After that transaction has been completed (usually in one business day), you do a Roth conversion.
However, your pre-existing traditional IRAs will likely be entirely deductible contributions and their pre-tax earnings. When you do a Roth conversion, you cannot limit your conversion to just your nondeductible contribution. When filing your income taxes, Form 8606 considers all your traditional IRAs as if the accounts were merged in one traditional IRA, regardless of which account the Roth conversion money came from.
For example: If your nondeductible contribution is only 25% of all the money in your traditional IRAs, then only 25% of your Roth conversion amount will be tax-free. The remaining 75% of your Roth conversion amount will represent the deductible (pre-tax) money across all of your traditional IRAs. Consequently, you will owe tax (at your current income tax rate) on 75% of your Roth conversion amount (see Example 3a below). If you can transfer your pre-tax IRA funds to a solo 401(k), employer-sponsored 401k, or 403(b), then they will no longer be subject to taxation during the Roth conversion process.
However, in the cases where part of the conversion amount was taxed, some of your basis is considered to have been converted tax-free while some still remains for use with the rest of your traditional IRAs. Some of this basis will hang around until all of your traditional IRAs (as defined here) are empty and you will have to file Form 8606 each year until then.
To do a backdoor Roth, first make a regular contribution to a traditional IRA with your IRA custodian. You do not need to tell the custodian whether the contribution is deductible or not; it is just treated as an IRA contribution. The custodian does not know (or care) if any contribution is deductible or not. That is known only to you, the IRS (and your state, if you file state income taxes), and your tax preparer. In fact, you can change your mind as to any contribution being deductible or not, up until the time you file your tax return.
"Nondeductible" simply means that you do not deduct the IRA contribution on your 1040 tax form. The transaction is recorded on Form 8606 instead and submitted with your tax return. This nondeductible contribution becomes your "basis" if you don't yet have any or is added to your existing "basis" when you prepare your taxes. One important thing to know about your basis, is that it does not grow, except by making additional nondeductible contributions. All the growth for the traditional IRA will instead be pre-tax.
The amount of the nondeductible contribution is limited to the maximum you are eligible to contribute each year, after taking other IRA contributions for the year into account. For example, the maximum IRA contribution in 2019 is $6,000 per person (or $7,000 if over age 50). If you are eligible for and thus make a $2,000 Roth contribution, you can only make a $4,000 (deductible or nondeductible) contribution to a traditional IRA. You cannot contribute more than your taxable compensation for the year. Non-working married spouses can also contribute to their own IRAs, even if they did not earn any income. The total contribution for both spouses cannot be greater than the total joint taxable compensation.
The contribution can be made up until the April filing deadline of the following year. The conversion can be done any time after that. In this case, the nondeductible contribution is reported on Form 8606 for the tax year it applied to, but won't impact the taxes for that tax year. The conversion will be reported for the year in which it happened (along with the carried-forward basis). Converting in a later year than the year of contribution would be useful for someone rolling over their traditional / rollover IRA to a 401K at year end where it is not completed by December 31. However, Form 8606 would then need to be filed for both years.
After the contribution transaction is complete, convert it to a Roth IRA. (You can also convert more or less than that amount, as will be shown in the examples below.) The Roth account may be an existing or new account. Accomplish this transaction by "moving" or "exchanging" the cash/shares in your traditional IRA and use the cash/shares to buy cash/shares in a Roth IRA. As an example, at Vanguard, this is implemented as a fund exchange. Go to the traditional IRA and select "Exch" which is listed next to "Buy" and "Sell." Identify the cash/shares to be moved. Then select the Roth account on the right hand side, and select the destination fund.
Another way to convert is to call the custodian and ask them to do it by giving the originating and destination account numbers and the amount (or fund) to convert.
If you didn't have any pre-existing traditional IRAs and your contribution was nondeductible one would normally convert the entire balance, even if the balance is higher or lower than the amount that was contributed. You pay tax only on the growth, if any, above the amount contributed. If you held the nondeductible contributions in the traditional IRA for only a few days, the tax should be minimal.
If you had pre-existing traditional IRAs, and your contribution was nondeductible, the contribution amount is considered your basis and the tax will be pro-rated over all conversions and withdrawals, until the traditional IRAs are empty.
If you have pre-tax money in any traditional IRA, the taxable portion of any conversion you make is prorated over all your traditional IRAs; you cannot convert just the nondeductible amount. There are three options for how to deal with an existing traditional IRA getting in the way of a backdoor Roth IRA:
- Convert the entire traditional IRA to Roth, and pay tax on the pre-tax amount of the conversion. For a small traditional IRA this may be the easiest and best option, but if the traditional IRA is large, this will result in a large tax bill. If you are making backdoor Roth IRA contributions, you are in a middle or high tax bracket, so this might be undesirable.
- Roll the pre-tax portion of the traditional IRA into your 401(k) or 403(b) or 457(b) at work, assuming it accepts rollovers. If the employer plan has poor investment options and/or high fees, this may be undesirable. However, if the employer plan is large and well-managed, it may have access to institutional share classes with even lower expenses than are available in the IRA.
- Start a business, open an Individual 401(k) that accepts rollovers, and roll over the traditional IRA into the Individual 401(k). The amount of the rollover is not limited by the amount earned by the business. For example, a $10M traditional IRA can be rolled into an Individual 401(k) opened on $10 of legitimately-earned self employment income.
In any case, you have until December 31st of the tax year in which you make the backdoor Roth IRA conversion to dispose of the traditional IRA. If you still have a traditional IRA balance on December 31st, then the pro-rata rule will apply to the conversion. For example, if you attempt to make a backdoor Roth IRA contribution of $6,000 while having a traditional IRA with a pre-tax balance of $50,000, then only 10.7% ($6,000 / ($50,000 + $6,000)) of the conversion step will apply to the non-deductible amount, and the remainder will be converted from the pre-tax amount. This will result in $5,357 ($6,000 * (1 - 10.7%)) of taxable income.
Because IRAs are individual accounts, the IRAs of one spouse do not affect the proration of the other spouse's conversion, even when filing MFJ. Similarly, if an individual has an inherited IRA with some basis in it as well as their own traditional IRAs (with or without basis), the tax calculations for the inherited IRA are done separately from the other traditional IRAs the beneficiary may have. In these cases, spouses need to file Form 8606 individually as well as for each inherited IRA having a basis.
When you leave an employer and you want to roll the employer's retirement plan to an IRA, request a single distribution but direct the after-tax distributions to a Roth IRA and the pre-tax distributions to a rollover IRA (which is one of the forms of a traditional IRA). While money is in the rollover IRA, DO NOT make any other contributions directly to that account. This will help make it possible for a future employer plan to accept the rollover IRA, since some employer plans do not accept money from contributory traditional IRAs (IRAs to which you contributed directly, instead of withheld from your paycheck). In other words, keep your rollover IRAs separated from your other IRAs. If you have already co-mingled employer plan rollovers with IRAs you have contributed to, the plan documents from a future employer plan will tell if the rollover back to a 401k or 403b is allowed.
Before you start the backdoor Roth, you should also understand IRS Form 8606 (which will be demonstrated below), as it will be filed with your income taxes for the year. Fill out a rough draft of the form to understand the tax implications and see if the contribution or conversion impacts anything else in your tax situation. The front of the form deals with your basis from the previous and the current year, while part of the back of the form deals with the Roth conversion. Understanding this formula will help you see what part of your Roth conversion or traditional IRA withdrawal will be tax-free and how much will be taxed:
ND = Amount of basis remaining from the previous year plus nondeductible contributions made for this year
SB = Sum of the balances of all your traditional IRAs at year-end plus the amount withdrawn from traditional IRAs (but not converted) plus the amount converted
TF = The percentage of the amount you convert (or withdraw without converting) that is tax-free for the year
- TF = 100 * ( ND / SB )
Examples with Form 8606
The following examples have graphics to illustrate the pro rata rule. This color key describes the tax status of the various portions of the money.
Note that the (yellow) basis is not part of any particular physical account. It is just an accounting device to help one see how and why it needs to be reported to the IRS for any year where it increases or decreases.
A chart showing the data to be entered on Form 8606 for each example follows at the end.
Example 1 Ann has no traditional IRAs. She knows she will pay the same amount of tax on $6,000 of her high income (for 2019) whether she deposits it into her taxable account or puts it in a Roth. She is ineligible to contribute to the Roth directly due to her high income. So it is a no-brainer to her to put it in a Roth where it can grow tax-free. She opens up a new traditional IRA and deposits $6,000 in it and will declare it as a nondeductible contribution when she files her taxes. A few days later, she converts all of it to her Roth. The tax-free amount of the conversion is:
- TF = 100 * [ 6,000 / 6,000 ] which is 100%.
Example 1a Ann made the contribution right before a holiday and forgot to convert the following business day. When she remembered it, the traditional IRA balance had grown $60. So now she has a basis of $6,000 and the account value is $6,060. The tax-free amount of the conversion is:
- TF = 100 * [ 6,000 / 6,060 ] which is 99%.
If she converts it all, she will pay taxes on 1% of the conversion amount ($60). Although there is rounding in the percentage, she will be able to subtract her basis ($6,000) from the converted amount. There will be no basis left.
If she only converts the $6,000, 99% of the $6,000 basis ($5,940) will go with the converted amount and 1% of the basis ($60) will remain behind. So she would still need to pay taxes on the $60 that was converted but was not tax-free. Next year, she can convert the remaining $60 tax-free since it has a $60 basis, assuming there is no growth meanwhile. To keep things simple, she decides to convert all of it now.
Example 1b Ann made the contribution right before a holiday and forgot to convert the following business day. When she remembered it, the traditional IRA balance had fallen $60. So now she has a basis of $6,000 and the account value is $5,940. The tax-free amount of the conversion is:
- TF = 100 * [ 6,000 / 5,940 ] which is 101%.
Since the tax-free percentage cannot be more than 100%, it resets to 100%. If she converts it all, she will pay no taxes on the conversion. What happens with the remaining basis ($60) is unclear. Leaving a dollar in the account and converting $5,939 might make it more likely she will retain $61 basis instead of losing $60 basis. This will be useful if she has future growth (or a deductible contribution of at least $61) in her traditional IRA since $61 of it will be able to be converted tax-free. See Is form 8606 TIRA basis lost after backdoor roth? for more discussion.
Example 2 Ben has $50,000 of deductible contributions and its growth in his traditional IRA and has some taxable money he can use to pay most (but not all) of the conversion taxes. He also has a rollover IRA with $350,000 that contains only a 401K rolled over from a former employer and growth since the rollover. He is not eligible to contribute to a Roth directly but wants to do a backdoor Roth. It will be his first time for a backdoor Roth and he thinks he also will like to do one in the following year as he will also convert half of the traditional IRA each year.
Example 2a This year, before Ben starts the backdoor Roth, he rolls over the rollover IRA into a new 401K he has with a new employer.
Then he makes a nondeductible contribution of $6,000 to his traditional IRA, which brings the account value up to $56,000. Then he converts half of the IRA ($28,000), saving the other half for a Roth conversion in the following year. But by the end of the year, the $28,000 remaining in the traditional IRA grows another $4,000 giving the IRA a year-end value of $32,000. (Note that the Roth may have also grown the same amount.) The tax-free amount of the conversion is:
- TF = 100 * [ 6,000 / (32,000 + 0 + 28,000) ] = 100 * [ 6,000 / 60,000 ] which is 10%.
This makes 10% of his $28,000 conversion ($2,800) be tax free and $25,200 (28,000 - 2,800) will be taxed. It also leaves $3,200 of his basis unused (6,000 - 2,800).
Example 2b In the following year, if he converts before the account changes value again, Ben will withdraw the amount of $32,000, but this time he messes up and withholds 15% ($4,800) for federal taxes. This is a withdrawal amount that is NOT converted and there will be a 10% penalty on the pre-tax portion of the withheld amount, in additional to income tax, for early withdrawal if he is not yet 59.5. (Penalties are calculated on Form 5329.) He converts the remaining $27,200. A while later in the year, he makes a nondeductible contribution of $6,000 and converts it the following day. At the end of the year, his traditional IRAs are all empty. For this following year, there will be a tax-free amount of:
- TF = 100 * [(3,200 + 6,000) / (0 + 4,800 + 27,200 + 6,000)] = 100 * [ 9,200 / 38,000 ] which is 24.21%
This makes 24.21% of his $4,800 withdrawal ($1,162) and 24.21% of his $27,200 + $6,000 conversions ($8,038) be tax free. That leaves $3,638 of the withdrawal for tax withholding ($4,800 - 1,162) and $25,162 of the two conversions ($33,200 - 8,038) to be taxed. It also leaves no basis (or any other money) in his traditional IRA.
Note that the IRS is still holding the entire $4,800 to apply to his tax liability although part of that withholding is not taxed (ie, $1,162). That is just like the Roth holding the entire $33,200 ($27,200 + 6,000) even though some of it is not taxed (ie, $8,038).
Example 3 Chris is nearing retirement and wants to be ready to do some large Roth conversions on her 401K before starting Social Security. She plans to roll some of it into a traditional IRA right after she retires, but will leave it alone for this year and next. But to clean things up before then, she wants to 1) finish converting her small SEP-IRA from a former employer, 2) do a backdoor Roth each year while working, and 3) draw down an inherited traditional IRA from her mother. Her mother had been doing backdoor Roths but died before she had converted everything in her traditional IRA.
Inherited traditional IRAs and inherited Roth IRAs can not receive new contributions nor be converted. They can only have withdrawals taken out. Although Chris had inherited half of her mother's traditional IRA and Roth IRA, the inherited Roth IRA is irrelevant to this example. But the remaining basis in the inherited traditional IRA still needs to be addressed (and is useful for account owners to know if they will be leaving basis in their traditional IRAs for their heirs).
Example 3a Chris needs to process her own accounts separate from the inherited IRA. Her SEP-IRA only contains $15,000 and she wants to do a $5,000 backdoor Roth. She opens up a new traditional IRA account and makes the $5,000 nondeductible contribution to it. Between the two accounts, they total $20,000 and $5,000 is the basis. She converts the entire traditional IRA and $5,000 of the SEP-IRA, leaving only $10,000 in the SEP-IRA at the end of the year. To calculate the tax-free part of the $10,000 in Roth conversions:
- TF = 100 * [ 5,000 / (10,000 + 0 + 10,000) ] = 100 * [ 5,000 / 20,000 ] = which is 25%.
This makes 25% of her $10,000 conversion ($2,500) be tax-free and $7,500 (10,000 - 2,500) will be taxed. It also leaves $2,500 of her basis (5,000 - 2,500) left for a future year.
Example 3b The remaining account value of the inherited (traditional) IRA is $60,000 of which $20,000 is the remaining basis from the previous year. (When receiving the inherited IRA, if the deceased had high compensation, the executor or trustee of the estate should look at the deceased's past tax returns to see if there was remaining basis reported on Form 8606.) Withdrawals from an inherited IRA cannot be converted. In the current year, Chris withdraws $40,000 (more than her Required Minimum Distribution) and the tax-free percentage of the inherited IRA withdrawal is:
- TF = 100 * [ 20,000 / (20,000 + 40,000 + 0) ] = 100 * [ 20,000 / 60,000 ] = which is 33.33%.
This makes 33.33% of her $40,000 withdrawal ($13,333) be tax-free and $26,667 (40,000 - 13,333) will be taxed. It also leaves $6,667 of her basis (20,000 - 13,333) left for a future year.
Chris will need to file two Form 8606s for the year, one for her own accounts and one for the inherited IRA. They will maintain separate carry-over bases. If she is married, her spouse will also have to file a separate Form 8606 with a separate pro rata calculation, if needed.
Form 8606 calculations
The chart below shows how Form 8606 would be filled out for each example above. An example Form 8606 follows.
|Form 8606 chart|
|2017 Form 8606|
Using tax software
To report a full backdoor Roth procedure in Turbo Tax (at least, and possibly in other software), it is often helpful to skip the tax software's default order of data entry, which asks you about income first, and IRA contributions later.
Enter your other income and wages as usual, but do NOT enter the 1099-R from your IRA distribution on your first pass. Instead, after entering other income, navigate manually to the IRA contribution section. You can do this by clicking on the tabs for 'Federal Taxes', then scroll down under 'Deductions and Credits' to the 'Retirement and Investments' section, and click on the 'Start' button for contributions. As noted above, in the backdoor process, you made a contribution to a traditional IRA, so that's what you report -- not a Roth contribution.
Once you've completed the contributions section, use the manual navigation again to go back to the income section, and now enter the information from the 1099R that reports the distribution from that tIRA. This step reports the conversion of the traditional IRA to Roth IRA. Be careful to enter exactly which boxes were checked for the distribution.
Once you're done with both the contribution and the 1099-R steps, use the 'Forms' view to check that your Form 8606 has been created correctly.
For examples of screen shots while doing data entry in popular tax software programs, you can also look at The Finance Buff's blog pages for TaxAct, TurboTax, H&R Block software, or FreeTaxUSA.
To see how multiple years of From 8606 should look (e.g., if one neglected to file several years and now wants to rectify things), or to see the interaction between Form 8606 and Worksheet 1-1 in Publication 590-B, the 'Form8606' tab of the Personal finance toolbox is useful.
- "Publication 590-A (2017), Contributions to Individual Retirement Arrangements (IRAs)". Internal Revenue Service. Retrieved December 30, 2018.
- "Publication 590-B (2017), Distributions from Individual Retirement Arrangements (IRAs)". Internal Revenue Service. Retrieved December 11, 2018.
- Rollovers of After-Tax Contributions in Retirement Plans, IRS, viewed August 7, 2016.
- Bogleheads® forum post: , crit. 31 December 2018.
- "How to Report Backdoor Roth in TaxAct". The Finance Buff. Retrieved January 1, 2019.
- "How to Report Backdoor Roth in TurboTax". The Finance Buff. Retrieved January 1, 2019.
- "How to Report Backdoor Roth in H&R Block Software". The Finance Buff. Retrieved January 1, 2019.
- "How to Report Backdoor Roth in FreeTaxUSA". The Finance Buff. Retrieved January 1, 2019.
- The MMM Case Study Spreadsheet, The Mr. Money Mustache Community, viewed Jan. 23, 2019.
- Bogleheads® forum topic: , celia. Dec 08, 2018
- Bogleheads® forum topic:
- Bogleheads® forum post: , a step-by-step backdoor Roth conversion made easy, by forum member Duckie.
- The Backdoor Roth IRA: A Complete How-To, by The Finance Buff (forum member, tfb)
- BackDoor Roth IRA Tutorial, by Jim Dahle (forum member White Coat Investor)
- 17 Ways to Screw Up a Backdoor Roth IRA, by Jim Dahle (forum member White Coat Investor)
- The benefits of a "backdoor" Roth, by Vanguard Research, November 2014, viewed December 11, 2018.