Last week I wrote about how to use a backdoor approach to get around the income limit of your Roth IRA contributions. I mentioned at the end of my post that there are drawbacks to this maneuver and listed five reasons you should pay close attention when making your backdoor Roth conversion.
1. You may trigger Pro-Rata Rule. If you have another IRA account or if you have more money in your current traditional IRA account than what you are converting in a given year, your conversion is subject to Pro-Rata Rule. The details on how to calculate the taxes can be found on this document. You essentially get double taxed on a portion or all of your conversion. My advice is don’t keep anything in any other IRA accounts and avoid triggering Pro-Rata Rule all together.
If you already have money in a previous account of traditional IRA or Sep IRA and still want to do a backdoor IRA, it will likely trigger Pro-Rata Rule. You need to figure out ways to empty your other IRA accounts. For example, if your employer offers a 401k that allows rollover from your IRA. Or if you have a side hustle that allows you to open an individual 401k, you can rollover your IRA to this individual 401k, too. All your non-deductible IRA contributions can be converted to Roth.
2.Contributing to a Backdoor Roth may complicate your tax filing. I think the worst part about contributing to a backdoor Roth IRA is the pain that is filing the tax return correctly. I use H&R Block to file my taxes. Every year I spend hours going back and forth in the tax filing software scratching my head trying to confirm that I filled out the form correctly. I will write a separate post to illustrate the correct steps to file your backdoor Roth IRA on your tax return using H&R Block.
Backdoor Roth makes it even more complicated if you make a mistake in the contribution and/or the conversion process. So make sure you pay attention when you make your contribution and conversion. When you make the conversion, you want to make sure it was a conversion not a rollover or recharacterization. I have made all those mistakes and paid for them painfully when I was filling out my tax forms.
It is more difficult if you make contributions in one year and make the conversion in another because it will require you to amend your prior year 8606 form. I recommend you avoid this headache by contributing and converting IN the same year FOR that year.
3.You may be taxed on growth in between contribution and conversion. Remember I mentioned that I convert my yearly contributions as soon as I see it appear on my account in step 2? Well, I learned it the hard way. I contributed to my traditional IRA one year and invested that money in the market. When I came back to make the conversion months later, my contributions had grown 15%. Unfortunately, that growth is taxable at my ordinary income tax rate at the time of conversion! Had I made the conversion immediately after contribution and invested it in the same assets, that growth would’ve been tax free!
4.There remains legality concerns. There is still a small legal risk to what I suggested in step 3. Even though each of the steps you take (i.e. contributing to your traditional IRA and conversion of Roth IRA) in a backdoor Roth IRA contribution is legal. The combination of these legal steps CAN be ruled as illegal. There is a judicial doctrine called step transaction doctrine which basically says a court can invalidate a transaction “if the separate steps involved in the transaction have no independent substantial business purpose.” In other words, IRS can look at your conversion which was done too quickly after the contribution and invoke step-transaction doctrine to invalidate it. There has been no court precedent of such a case so I have not paid too much attention to it. Backdoor Roth IRAs have become so popular and so prevalent that retrospectively invalidating this conversion process seems unlikely.
5.Your Roth IRA conversion is now irreversible. Before 2018, you could do a conversion to your Roth IRA and recharacterize back to traditional IRA because you found that you are better off contributing to a traditional IRA. Starting with 2018 contribution, the new tax regulations disallowed this backward recharacterization. In other words, once you make a conversion (or backdoor Roth contribution), it is final.
What do you think? Are you taking advantage of backdoor Roth IRA? Anything else you think people should pay attention to when they do a backdoor contribution? Leave me a comment below.