'Backdoor' Roth Conversion

[wilkieca]

My spouse and I do not qualify for tax-deductible IRA contributions due to income limits.  Typically I make a contribution and then do a back-door conversion the same year.

I did not do that in 2019 for my spouses contribution, but did it in 2020 converting the entire value of the account.   We made a max $6K contribution (not deductible) in both 2019 and 2020, and then converted that account to a ROTH through our brokerage account.   The total amount converted was less than the $12K we put in.

That same year, my spouse transitioned to a different job and we converted her small 401K to an IRA in the same account.  We received a 1099R for that conversion and have entered that detail.

When we fill in the form, we walk through the steps to indicate that there was a 6K contribution in 2019 and a 6K contribution in 2020 and that we converted the entire amount (again, less than 12K) into a Roth.

When we are asked what the current balance of the Trad IRA at the end of 2020 is, it now has all of the rolled over 401k  money  in it.    If I put that balance in there, turbotax calculates that we have a taxable gain of many thousands of dollars (and our tax burden increases).   If we leave that blank, it identifies that the Roth conversion was not taxable.

Did I make a mistake in entering the information into the forms?  Did I make a mistake in doing two conversions (a IRA->Roth and a 401k->IRA) in the same year?  Or did turbotax make a mistake in calculating the tax burden of the conversion and rollover?

Help!

[macuser_22]

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@wilkieca wrote:

Did I make a mistake in entering the information into the forms?  Did I make a mistake in doing two conversions (a IRA->Roth and a 401k->IRA) in the same year?  Or did turbotax make a mistake in calculating the tax burden of the conversion and rollover?

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Yes, your mistake was trying to do a"backdoor Roth" if the Traditional IRA value would not be ZERO at the end of the year.    The non-deducible "basis" must be prorated over the 2020 distribution and the total value of nay existing Traditional, SEP or SIMPLE IRA as of Dec. 31, 2020.

The original circulations were correct.  Probably most of the Roth conversion will be taxable.

You can NEVER withdraw ONLY the nondeductible part - it must be prorated over the entire value of ALL Traditional IRA accounts which include SEP and SIMPLE IRA's. (For tax purposes you only have ONE Traditional IRA which can be split between as many different accounts as you want, but for tax purposes they are all added together).

For example using rough figures: if you had $60K of nondeductible contributions in an IRA with a total value of $600K (10:1 ratio), then when you take a $60K distribution from any IRA account $6,000 would be nontaxable and $54,000 would be taxable (same 10:1 ratio) , with the remaining $54K of basis staying in the IRA for future distributions. As long as there is any money in the IRA, there will be some basis.

TurboTax will ask for your non-deductible "basis" and then the *Total Value* of *all* Traditional IRA, SEP and SIMPLE accounts as of Dec 31, of the tax year. That is so the prorating of the basis can be properly proportioned between the current years distribution and the remaining IRA value. That is done on the 8606 form.

The "Backdoor Roth" does not exist in tax law. It is a procedure used by some to take advantage of a quirk in tax law that allows making a non-deductible contribution to a Traditional IRA when one cannot contribute to a Roth IRA, and the immediately converting the Traditional IRA to a Roth IRA, thereby getting the money into the Roth via "backdoor" tax free.

That "procedure" can only work of all these requirements are met:
1) No Traditional IRA account whatsoever can exist (that includes any SEP or SIMPLE IRA accounts) at the start. If existing IRA's contain any before-tax money or earnings then it will be partly taxable.
2) The Tradition IRA contributions must be reported on a 8606 form as non-deductible.
3) The conversion to a ROTH must be shortly after the contribution to avoid taxable gains.
4) The entire Traditional IRA value must be zero that the end of the year of conversion.

Otherwise the conversion will be partly taxable.

[wilkieca]

Thank you for your answer.

At the time the conversion took place, it was the complete account.   The 401k->Trad conversion took place after the conversion.   So I suppose that was the mistake.

I imagine there is nothing to do to repair the damage.

Regards

[macuser_22]

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@wilkieca wrote:

Thank you for your answer.

At the time the conversion took place, it was the complete account.   The 401k->Trad conversion took place after the conversion.   So I suppose that was the mistake.

I imagine there is nothing to do to repair the damage.

Regards

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Unfortunately that is the result of not having a zero IRA at years end.    2020 is over so nothing can be done now.    The taxable amount on future IRA distributions will be reduced on a pro-rated amount for as long as the IRA exists but if the after- tax "basis" is small compared to the IRA value then that tax reduction will also be small.