Excess Roth IRA contribution, backdoor Roth IRA process

[DKEBeck88]

My wife and I each have used monthly direct deposits to max out our Roth IRAs each of the last few years.  In March of this year my wife got a new job with a substantial pay increase that took us from slightly below the beginning of the Roth contribution phase out all the way past the maximum MAGI for any Roth contributions.  We immediately stopped our automatic Roth contributions.  I knew we'd need to do something about the already-contributed money, but I left that as a problem for the future.

Fast forward to the future and I think I know what we need to do, but I'd like some confirmation that I'm on the right track.  I'd like to both withdrawal our respective excess 2021 direct contribution amounts and associated earnings from our Roths, and then also contribute maximum ($6k) each to a traditional IRA and then convert/transfer that to our existing Roth IRAs ("backdoor Roth").  Ideally I'd do this before the end of calendar year 2021 to make tax prep easier.

I have never had a traditional IRA, so I opened one up with the same company I have my Roth.  My wife has an old Rollover IRA with about $20k.  In preparation for the backdoor Roth move, she has moved all of that pre-tax money from the Rollover IRA to her current employer's 401k, leaving her with $0 in pre-tax IRA money.  She also opened up a new traditional IRA with the same company as her Roth, because I couldn't tell if a Rollover IRA would work for the backdoor IRA process.

OK, all that being said, I think my steps are:

1) withdrawal our excess Roth contributions and associated earnings

2) contribute $6k to our traditional IRAs, putting the money in a non-earning holding position

3) immediately (within a few days?) convert everything in our traditional IRAs to our existing Roth IRAs

My understanding is:

1) we'll owe taxes and possibly 10% early withdrawal penalty on the earnings on the excess contributions since we're not 59.5 years old

2) my wife's transfer of the money in her rollover IRA to her 401k (both pre-tax) leaving her with $0 in pre-tax IRA money means she won't owe any taxes on the backdoor IRA conversion.

How long do I need to wait between contributing to the traditional IRA and converting that to Roth?

Am I missing or overlooking anything?  Any gotchas?

[macuser_22 · Accepted solution]

What you posted is correct.   As an alliterative, you can have the IRA custodian recharacterize the contribution (and earnings) to a Traditional IRA as if the Roth contribution never happened ans it was a Traditional IRA contribution in the first place.    Either way the procedure is what you outlined.

Your question: "How long do I need to wait between contributing to the traditional IRA and converting that to Roth?"

Immediately - many people have the financial institution recharactorize and then convedrt to a Roth is the same visit or phone call.

[Note: years below are for the 2020 tax year, substitute 2021 for 2021]

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.

First you must enter your Traditional IRA contributions (if there were 2020 contributions).

IRA contribution
Federal Taxes,
Deductions & Credits,
I’ll choose what I work on (if that screen comes up),,
Retirement & Investments,
Traditional & Roth IRA contribution.

Be SURE to answer the follow up that the are choosing to make this contribution NON-DEDUCTIBLE - if that screen comes up. (DO NOT say that you moved (recharacterized) the money to a Roth) – this is a conversion, not a recharactorazition.

Then enter the 1099-R that shows the distribution.

Federal Taxes,
Wages & Income
I’ll choose what I work on (if that screen comes up),,
Retirement Plans & Social Security,
IRA, 401(k), Pension Plan Withdrawals (1099-R).

Answer the follow-up questions answer the question that you moved the money to another retirement. The screen will open up with choices of where it was moved. Choose you converted it to Roth IRA.

When asked if you have made any non-deductible contributions say " "yes" if you did then enter the non-deductible contributions made for tax years before 2020.     (Usually zero unless you also made a 2019 or earlier non-deductible contribution. If you do have prior year basis then enter the last filed 8606 line 14 value.).

Enter the 2020 year end value of your Traditional IRA a "0" (zero) - if it is in fact zero - this tax free Roth conversion will not work if it is not zero.

[If you had any other Traditional IRA at the end of 2020, then the nondeductible "basis" must be pro-rated over the current distribution and the total IRA value and only a portion of the Roth conversion will be non taxable and part will be taxable, with the remaining non-deductible basis carrying forward for future distributions. You can never only withdrew the nondeductible basis as long as the IRA exists and has a value more than zero.]

The non-deductible amount of your contribution will be subtracted from the taxable amount of the conversion on then 8606 form and enter on line 4a of them 1040 form and a zero taxable amount on line 4b if you did it right.

Also see this TurboTax FAQ:
https://ttlc.intuit.com/questions/4350747-how-do-i-enter-a-backdoor-roth-ira-conversion

[Opus 17]

Be careful @DKEBeck88 and @macuser_22 

The taxpayer here said "automatic payroll deductions."

It is very important to understand that qualified workplace plans (401k, 403b, etc.) are NOT IRAs, even though they have similar purposes.  They have different contribution limits, different income limits, and different rollover rules.

If by "automatic payroll deduction" you mean you set up a direct deposit of part of your paycheck to a bank that was holding a private IRA for you, then @macuser_22 's comments are correct.  However, if you were contributing to a Roth option account within a qualified workplace retirement plan, then we have to start from scratch.

[DKEBeck88]

@Opus 17  Oops, I did actually mean "direct deposit" and not "payroll deduction."  We both have payroll deductions to our pre-tax workplace plans (a 403b for me and a 401k for her) and both had $500/month direct deposit to our private Roth IRAs before putting a stop to those early this year.  Thanks for the extra attention - very much appreciated.  I'll update my original post to fix the language.

[fanfare]

"The "Backdoor Roth" does not exist in tax law."

Maybe so, but Congress is getting ready to pass legislation to make this impossible.

In that case, will it exist, will have existed or no longer have existed in tax law?

[fanfare]

1 (A) IN GENERAL.—Paragraph (1) of sec2 tion 408A(e) is amended by adding at the end
3 the following new sentence: ‘‘A qualified rollover
4 contribution shall not include any rollover con-
5 tribution from any eligible retirement plan de-
6 scribed in subparagraph (B) (other than from a
7 designated Roth account (within the meaning of
8 section 402A)) if any portion of the distribution
9 from which such contribution is made would
10 (without regard to such contribution) be treated
11 as not includible in gross income.’’