Untitled Document

March 2022

Understanding the Making of a Backdoor Roth IRA Contribution

The law expressly provides that individuals with high incomes are ineligible to make an annual Roth IRA contribution. However, the law permits an individual with any income, even a high income, to make a nondeductible traditional IRA contribution. Another law permits a person with a traditional IRA, SEP-IRA or SIMPLE IRA, regardless of income to make a Roth IRA conversion contribution.

So a person with a high income is able to make a non-deductible traditional IRA contribution and then convert that contribution into a Roth IRA. The net effect is the same as making a direct Roth IRA contribution. This is the back-door Roth IRA contribution.

Some people seem to think there is one transaction to make a back-door Roth IRA contribution. There isn’t. There are always two transactions - make a non-deductible contribution to a traditional IRA and then convert it to a Roth IRA. Note, the person must not have any traditional IRA, SEP-IRA or SIMPLE IRA holding any taxable funds to make a true back-door Roth IRA contribution.

The second transaction (i.e. the conversion) may happen immediately after making the non-deductible contribution or it may occur later. Most individuals will want to do the conversion as soon as possible so that any earnings occur within the Roth IRA and not in the traditional IRA. Earnings within in a traditional IRA are always taxable.

A 2021 non-deductible traditional IRA may be made from January 1, 2021, through April 18, 2022. This non-deductible traditional IRA contribution must comply with the IRA contribution limit (lesser of 100% of compensation or $6000/$7000).

A 2021 conversion contribution must be made between January 1, 2021 through December 31, 2021. A 2022 conversion contribution must be made between January 1, 2021 through December 31, 2022.There is no conversion contribution limit other than the conversion amount cannot exceed the fair market value of the traditional IRA.

The tax consequences of these two transaction are easy to understand and to report on a person’s tax return if both transaction occur within the same tax year and for the same tax year.

For example, a person who makes a $6000 non-deductible contribution on August 7, 2021 for 2021 and also converts it on August 7 2021 will prepare their tax return showing - the making of the $6000 nondeductible contribution on the 2021 Form 8606, the conversion withdrawal of $6000 on the 2021 Form 8606 and the 2021 Form 1040 and the fact that no portion of the $6000 is to be included in income because it is basis.

In the above situation the IRA custodian will prepare the IRS reporting forms as follow::
1. The 2021 Form 5498 for the traditional IRA will show in box 1 a contribution of $6000;
2. The 2021 Form 1099-R will show a distribution of the $6000 from the traditional IRA (box 1 and 2a showing $6000, box 7 with a reason code 2 if under 591/2 and 7 if age 591/2 or older, and
3. The 2021 Form 5498 for the Roth IRA will show in box 3 a conversion contribution of $6000.
The person must complete their tax return (Forms 1040 and 8606) and explain - a conversion was done but the taxable portion is 0.000 because the converted amount of $6000 was 100% basis. That is, there were no earnings.

The tax consequences of these two transactions becomes more complicated when both transactions do not occur within the same tax year and for the same tax year. There are two situations to be illustrated.

Situation #1. A person makes a $6000 non-deductible contribution on August 7, 2021 for 2021 and then waits until April 7, 2022 to convert it. There are $300 of earnings between August 7, 2021 and April 7, 2022. The person must report the making of the $6000 nondeductible contribution on his 2021 tax return. Although not required it is assumed the person converts the entire $6300.The person must report the conversion of $6300 on his 2022 tax return, He will complete the Form 8606 and Form 1040 to show that $300 is included in income but $6000 will be excluded as it is basis. In the above situation the IRA custodian will prepare the IRS reporting forms as follow:
1. The 2021 Form 5498 for the traditional IRA will show in box 1 a contribution of $6000;
2. The 2022 Form 1099-R will show a conversion distribution of the $6300 from the traditional IRA (box 1 and 2a showing $6300, box 7 with a reason code 2 if under 591/2 and 7 if age 591/2 or older,
3. The 2022 Form 5498 for the Roth IRA will show in box 3 a conversion contribution of $6300.
The person must complete their 2021 Form 8606 to report the making of a nondeductible contribution. The person must also complete their 2022 tax return (Forms 1040 and 8606) and explain - a conversion distribution was done. $6000 is not taxable as it is basis, but the $300 is taxable.

Situation #2. A person makes a $6000 non-deductible contribution on April 7, 2022 for 2021 and then immediately converts it The person must report the making of the $6000 nondeductible contribution on his 2021 tax return. He must complete his 2021 Form 8606. He will report the making of his conversion contribution of $6000 on his 2022 tax return. He must complete his 2022 Form 8606 to report this conversion and his 2022 Form 1040 so that no portion of the distribution is included in his income. In the above situation the IRA custodian will prepare the IRS reporting forms as follow:
1. The 2021 Form 5498 for the traditional IRA will show in box 1 a contribution of $6000;
2. The 2022 Form 1099-R will show a conversion distribution of the $6300 from the traditional IRA (box 1 and 2a showing $6300, box 7 with a reason code 2 if under 591/2 and 7 if age 591/2 or older, and
3. The 2022 Form 5498 for the Roth IRA will show in box 3 a conversion contribution of $6300.
The person will prepare their tax return showing - the making of the $6000 nondeductible contribution on the 2021 Form 8606, the conversion withdrawal of $6000 on the 2022 Form 8606 and the 2022 Form 1040 and the fact that no portion of the $6000 is to be included in income because it is 100% basis.