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rubenandrea425
Level 1

Accidentally invested in Traditionally IRA instead of converting to Roth IRA

Hi There,

 

My wife was in the process of doing a backdoor Roth IRA conversion, she was supposed to transfer cash to her Traditional IRA, then move the funds to the Roth IRA account and then invest the money from the Roth IRA. Somehow she got confused and skipped step 2, she transferred cash to the Traditional IRA and instead of moving the cash to the Roth IRA, she invested the cash in her Traditional IRA.

 

  1. Does this make her non-eligible for Backdoor Roth conversion? I read a long time ago that one of the requisites for the backdoor conversion was that you couldn't have any other IRA active
  2. How can she undo this mistake? Can she just sell the shares she bought and transfer the cash to the Roth IRA like nothing happens? what happens if there was capital gains?

Thank you in advance.

3 Replies
Mike9241
Level 15

Accidentally invested in Traditionally IRA instead of converting to Roth IRA

if you leave the money in your traditional IRA, you could have earnings, and if you have earnings, you have to pay taxes on those earnings when you do your conversion. If you accumulate enough earnings and then convert your entire account balance, you’ll have an excess contribution you will have to correct by paying taxes. Any untaxed amounts in the traditional IRA will result in taxation after the conversion.

Here’s the catch, though: If you have pre-tax money sitting in any other traditional IRA accounts, your backdoor Roth conversion will trigger a tax bill, courtesy of the IRS’ pro-rata rule.  (this rule applies even if you contribute to an IRA and then immediately do a backdoor conversion) 

The Pro-Rata Rule and Backdoor Roth Conversions
For tax purposes, the IRS considers all your (seemingly separate) IRAs as one big account. The pro-rata rule boils down to the percentage of your total combined IRA balances that has yet to be taxed. Whatever that percentage is determines the percentage of your backdoor Roth IRA conversion that will be taxed.

For example, let’s say you have $94,000 in existing traditional IRAs that were funded with pre-tax dollars. And now you contribute $6,000 to a new traditional IRA with after-tax dollars, then immediately convert that $6,000 to a Roth via the backdoor Roth IRA strategy.

As far as the IRS is concerned, you now have $100,000 in traditional IRAs, and the $6,000 you are contributing with after-tax dollars represents 6% of your total. That means only $360 of your $6,000 backdoor conversion is tax-free (6% of $6,000). You owe income tax on the other $5,640 you backdoored.

Opus 17
Level 15

Accidentally invested in Traditionally IRA instead of converting to Roth IRA

I don't understand the concern.

 

First, she contributed money to a tradition pre-tax IRA.

Next, instead of leaving the money as cash, she bought some investments, still in the IRA.

Is that it?

That's no problem at all.  Just sell the investments and do a rollover to the Roth IRA.  What you do with money inside an IRA is largely irrelevant.  The backdoor Roth conversion can still happen whether the IRA balance is in a cash account or investments, it's just that the IRA trustee will have to sell the investments when you perform the rollover.  

 

Now understand, for a "back door Roth conversion" to work, a person has to rollover/convert their entire balance in traditional IRAs.  If your wife has two IRA accounts each with funds, she has to rollover both accounts, and if part of the balance is a pre-tax (deductible) contribution, there will be some tax on the conversion.  But moving money from a cash account to an investment within the IRA does not create a separate IRA.

*Answers are correct to the best of my ability at the time of posting but do not constitute legal or tax advice.*
dmertz
Level 15

Accidentally invested in Traditionally IRA instead of converting to Roth IRA

Nothing about the earnings in the traditional IRA causes an excess contribution.  Perhaps that was just poor wording by Mike9241.

 

Presumably there was nothing in your wife's traditional IRA(s) prior to the traditional IRA contribution in question.  There is nothing technically wrong with investing in the traditional IRA prior to doing the Roth conversion.  The only effect is that there could be an investment gain or loss prior to the conversion.  If there is a gain, a Roth conversion will be partially taxable.  If there is a loss, the Roth conversion of the entire account will be nontaxable but there will be some amount of unrecoverable traditional IRA basis.  Under these circumstances it's usually suggested that the IRA owner convert slightly less then the entire account; the slight remaining amount will preserve the basis and allow it to carry forward.

 

(As Mke9241 said, if your wife has other money in traditional IRAs, a Roth conversion will be partially or mostly taxable, with only a portion of the basis in nondeductible traditional IRA contributions applied to the conversion and the remainder staying in your wife's traditional IRA(s) to be applied to future distributions until there is no more money in her traditional IRAs at year end.)

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