How to Report a Backdoor Roth IRA Contribution on Your Taxes

How to Report a Backdoor Roth IRA Contribution on Your Taxes 

https://www.merriman.com/how-to-report-a-backdoor-roth-ira-contribution-on-your-taxes/

Updated January 2024

Tax Planning

By Geoff Curran, Wealth Advisor CPA/ABV, CFA®, CFP®
Published On 01/10/2024

Do you make over $250,000 a year and find that you are maxing out your 401(k)? Are you looking for other retirement savings options? If so, you’re in the right place, as this article will help you understand what a Backdoor Roth IRA is, how to make the contribution, and how to report it on your taxes (with real client stories along the way). As a bonus, you’ll also find helpful tax filing tips at the end of this article to aid you this April.

 
"What Is a Backdoor Roth IRA?"

A Backdoor Roth IRA is a process that allows high-income earners to still contribute to a Roth IRA. Since their income is too high to qualify for a regular (direct) contribution to a Roth IRA (where future growth and retirement distributions are tax-free), they can instead make a non-deductible Traditional IRA contribution, which is then converted to a Roth IRA tax-free. While the Backdoor Roth IRA is simple enough, the documentation and tax forms can be confusing (tax filing tips on this below).

 
"Eligibility for Backdoor Roth IRA Contributions"

The Backdoor Roth IRA makes the most sense for high-income households that have already maxed out their employer retirement accounts and are looking for the next best way to save and invest their hard-earned resources (and receive tax-free growth!).

 
Example:

William and Mary are in their late 30s with two young children. After a series of promotions, their household income is now above $400,000. With this increase in income, they have extra resources to plan for after already maxing out their 401(k) contributions. They are concerned about the need to maximize their savings and wealth (and future taxes) while also paying for childcare expenses now and college expenses in the future (in addition to trying to enjoy this busy time of their life!). Given their goals, they decide that each will contribute to a Backdoor Roth IRA to boost their tax-free retirement savings and 529 college savings plans to plan for their children’s college.

 
2024 Contribution Limits for Backdoor Roth IRAs

2024 contribution limit: $7,000 ($8,000 if age 50 or above)

 

2024 regular Roth IRA contribution income limit: $230,000 for a married couple and $146,000 for a single individual (or head of household); if you earn above these limits, you’ll need to contribute through a Backdoor Roth IRA

 
What Is the Actual Process?

Step one of the Backdoor Roth IRA is to make a non-deductible contribution to your Traditional IRA.

 

Step two, after making your non-deductible Traditional IRA contribution, is to convert your Traditional IRA balance to a Roth IRA. You will owe tax on any earnings in the Traditional IRA before converting, but from then on, those dollars are now Roth IRA assets and are not subject to future tax.

 
Reporting Your Backdoor Roth IRA on Tax Returns

Two parts of this process need to be properly tracked and reported on your tax return.

 
Part I: Contributions

It’s your responsibility to report the non-deductible contribution to your Traditional IRA at tax time on IRS form 8606, Nondeductible IRAs (separate forms are completed for each spouse’s contributions). Part I of Form 8606 helps track your basis so you can avoid paying additional tax on your non-deductible contribution as you convert the balance to a Roth IRA.

 
Part II: Roth IRA Conversions

Around tax time (mid-January in most cases), you’ll receive a 1099-R from your custodian showing the distribution from your Traditional IRA that was converted to your Roth IRA the previous year. Later in the year, you’ll also receive an information reporting Form 5498 that shows your contribution to the Traditional IRA and the amount that was converted to a Roth IRA (this form is for record-keeping purposes).

Part II of Form 8606 calculates the taxable amount from the conversion if you had any earnings in the Traditional IRA.

 
Example 1:

Tom, a 35-year-old physician in the Pacific Northwest and diehard Seahawks fan, is working on his Married Filing Jointly tax return after making a $6,500 non-deductible Traditional IRA contribution last year (2023 Roth IRA contribution limit) that he converted to his Roth IRA. Tom didn’t have any other Traditional IRA assets aside from his non-deductible contribution in 2023, and he didn’t have any earnings in his Roth IRA conversion. Part 1 of Tom’s Form 8606 is filled out below.

[img[https://www.merriman.com/wp-content/uploads/BackdoorRothBlogImage1.png]]
 
 

 

Next, let’s look at Part 2 of Tom’s Form 8606, where the conversion portion is reported. If line 18 is 0, as in this example, none of the conversion is taxable.

 
[img[https://www.merriman.com/wp-content/uploads/BackdoorRothBlogImage2.png]]

 

Tom won’t owe any taxes on his Backdoor Roth IRA, and his correct reporting of the contribution and conversion will help him avoid running afoul of the IRS.

 
Example 2:

Sally and John are in their early 40s and have just become Merriman clients. Sally is an orthodontist, and John works for Microsoft. Since they weren’t previously aware of the Backdoor Roth IRA contribution option, we completed both their 2023 ($6,500) and 2024 ($7,000) contributions on January 3, 2024. When preparing their 2023 tax return in April, they’ll each file a Form 8606 that includes the contribution made between January 1 and the April tax filing deadline. This will be the only information populated on the form for tax year 2023, as the 2024 contribution and both conversions will be reported on their 2024 tax return. When they prepare taxes for 2024, they’ll report the $6,500 previous year’s basis plus the additional $7,000 current year contribution in Part I and the $13,500 converted to a Roth IRA tax-free in Part II (as they have a $13,500 basis).

 
Benefits of Backdoor Roth IRA for High-Income Earners

    * Be aware that if you have existing pre-tax IRA assets (this includes SEP and SIMPLE IRAs), part of your conversion may be treated as a taxable Roth IRA conversion (versus tax-free). One workaround is to roll over your existing pre-tax IRA assets to a workplace 401(k) or a self-employed 401(k). For example, James had $100,000 of existing IRA assets prior to making a $7,000 contribution for 2024. If he tried to convert the $7,000 to a Roth IRA, only about 6.5% or $455 of the conversion would be considered tax-free (leaving $6,545 to be taxable) due to “IRA aggregation” rules.

    * If you have a basis (i.e., previous after-tax/non-deductible contributions) plus pre-tax assets in your existing IRA balance, like #1, you can complete a reverse rollover of the pre-tax portion of the assets to your employer 401(k) or self-employed 401(k) to isolate and convert the basis tax-free.

    * As hinted in Example #2 above, Form 8606 will populate differently if you contribute for the prior year between January 1 and the tax filing deadline in the new year. Be aware that the Roth IRA conversion piece (Part II of the form) is only reported in the year of conversion.

    * If you don’t immediately convert your non-deductible IRA contribution to a Roth IRA, there’s a chance that you’ll have earnings on the contribution. If this is the case, you’ll owe tax on the earnings piece when completing the Roth IRA conversion. For example, Jane contributed $7,000 to her non-deductible IRA on January 1st. By the time she decided to convert the balance to a Roth IRA, it had grown to $8,000 (with the help of the market going up). As a result of waiting to convert the balance, she now owes tax on the $1,000 of earnings (the $7,000 basis converts tax-free). If she had immediately converted the balance to a Roth IRA, this growth could have occurred in the Roth IRA tax-free.

    * If your income is below the Roth IRA contribution income limit, you can make a regular Roth IRA contribution. You can still make a Backdoor Roth IRA contribution; however, going through the logistical and reporting hassle isn’t necessary.

 
Other Essential Tax Filing Tips for 2024

    * Complete a Backdoor Roth IRA contribution: If this article speaks to your situation, consider contributing for both your spouse and you. Pay special attention to ensure you report this contribution on your taxes correctly!

    * File an extension: Whether life is too busy leading up to the April deadline or you are still waiting on tax forms from some of your investments or business, consider filing an extension. It’s perfectly fine to do this to ensure that you file by the October deadline with correct information (versus needing to take the time to amend the return months later due to reporting incorrect or incomplete information). Please keep in mind that you need to make sure that you’ve paid an estimate of what you think you owe for the year by the April deadline to avoid any penalties (the extension only extends your deadline to file your tax return, not pay your tax liability).

    * Make an estimated payment: If it’s January, February, or March, and you realize you’ll owe a hefty tax bill, it may make sense to make an additional estimated tax payment even before the April deadline. Doing this reduces how much of an under-withholding tax penalty you’ll owe. Now that tax penalties are much higher (due to the rise in interest rates), employees of large tech companies who receive a lot of their compensation in the form of employer stock (where they typically only withhold taxes at 22% on these vests) can benefit from this.

    * Determine if you can itemize deductions: With the rise in interest rates, people with mortgages and home equity lines of credit may be surprised that they can now itemize their deductions. Itemized deductions include medical bills, state and local taxes paid (including property and sales tax), mortgage interest, and charitable donations.

    * Childcare costs: Include your children’s tax IDs on your return and report your childcare costs correctly to ensure that you receive as much of the child and dependent care tax as you are eligible for. Too often, tax IDs are forgotten, or the childcare tax credit form is incorrectly filled out, causing families to miss out on this benefit.

    * Don’t forget about any tax-loss carry forwards: Double check that either your software or tax preparer has included any remaining tax losses from investments in prior years to offset future taxes. This is especially important to review if you are changing providers.

    * Ask for tax preparation help: It never hurts to evaluate whether you should hire a tax preparer to help you with this annual task. A tax professional can especially make sense if you find yourself owing a lot of tax penalties, made mistakes that need to be fixed, or now have a more complex tax picture than in prior years (i.e., rental properties, business, private investments, etc.).

 

If stressors like tax law changes, new forms, and confusion around the whole process keep you from sleeping soundly, reach out to a Merriman advisor to determine whether a Backdoor Roth IRA or other tax planning strategies make sense for you. You might even have other options available for tax-advantaged savings that you haven’t considered. Check out Mega Backdoor Roth Explained to see how you might be able to do a Backdoor Roth in your employer 401(k) plan. We love navigating complex issues like these and giving guidance to elevate your finances.    

 

References:

Internal Revenue Service. (2023, October 13). About Form 5498, IRA Contribution Information (Info Copy Only). Retrieved from https://www.irs.gov/forms-pubs/about-form-5498

Internal Revenue Service. (2023, March 9). About Form 8606, Nondeductible IRAs. Retrieved from https://www.irs.gov/forms-pubs/about-form-8606

Internal Revenue Service. (2023, November 13). About Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.. Retrieved from https://www.irs.gov/forms-pubs/about-form-1099-r