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Avoid These Two Backdoor Roth Conversion Mistakes!

Backdoor Roth conversions enable high-income earners to utilize Roth’s unique savings capabilities, allowing investment funds to grow tax-free. That’s because, as a high earner, you do not qualify to contribute directly to a Roth IRA if you earn more than $144,000 in 2022. If you are married and filing jointly, your income limit is $214,000.
The key word here is directly. If not directly, the only alternative is indirectly – by means of a Roth conversion. In this article, I won’t go over the merits of a Roth conversion or Backdoor Roth conversion in this article. Instead, I will clarify two potential and often overlooked errors when employing a Backdoor Roth conversion.

Backdoor Conversion Mistake #1: The Aggregation Rule

It is possible to have more than one IRA account, which in and of itself is not a problem. It may become an issue by failing to realize that the IRS considers multiple IRA accounts to be a single account for tax reasons. Things may get confusing, so bear with me.
You converted $50,000 of 401(K) funds into an IRA at a previous job. Years later, you open a separate IRA account to utilize a backdoor Roth conversion.
Next, you put $6,000 POST-TAX and non-deductible dollars into the IRA. Then, you convert those funds to Roth. To your surprise, you discover that you now owe taxes on $5,358 of taxable income! And you find yourself thinking, “How strange, I already paid taxes on that $6,000!”.

Pro-Rata Rule

Here, the ‘pro-rata’ rule comes into effect. Any conversions pull from both pre-and post-tax dollars proportionately. So, you had $56,000 in IRAs – $50,00 of them pre-tax, $6,000 post-tax. 10.7% of your IRA is post-tax, and 89.5 is pre-tax.
Breaking it down, we get the following numbers:
10.7% of $6,000 is tax-free, or $642.
89.3% of $6,000 is taxed, or $5,358.
I wonder if this is what you expected when you decided to implement a Backdoor Roth conversion strategy!
But don’t worry; you don’t have to combine all your IRA accounts into one for tax purposes during a Backdoor Roth conversion. Any existing Roth accounts, your spouse’s IRA, or any inherited IRAs can be left off the balance sheet.

Backdoor Conversion Mistake #2: The Step Transaction Doctrine

The IRS loves to look at the bigger picture. If a series of small and legal steps lead to tax relief, the IRS may block those loopholes because they see the result that the small steps lead to.
It’s basically opposite the old adage, “It’s about the journey, not the destination.” For the IRS, it’s all about the destination, regardless of how you got there. So, the less obvious the steps are connected, the better.
  1. Open an IRA.
  2. Put post-tax funds into a money market fund to reduce volatility.
  3. Wait an appropriate amount of time (how long is tricky).
  4. Convert the funds to Roth
  5. Purchase your preferred investments.
  6. Roll over other tax-deferred IRAs to avoid pro-rata taxation.
  7. File your taxes along with form Form 8606.

Take The steps slowly

The issue is that, on their own, each of these steps is entirely normal. But, if you execute these steps too quickly, one right after the other, the Step Transaction Rule may come into effect. Therefore, it is best to wait a bit between each step. Unfortunately, there is no cut-and-dry time limit. One month may cut things too close, while a year, though probably safe, is just too long.
The gist is this: the faster you complete the above steps, the more likely the IRS will disallow the transaction. The longer you wait, the greater chance that funds in a non-Roth account will gain in value, and you will need to pay income taxes on those gains upon conversion – hence why I advised putting the funds in a simple Money Market Fund.
However, if you believe you will wait quite a long time before implementing the Backdoor conversion just to play it safe, you should purchase safe ETFs or Mutual Funds and pay taxes on any gains you incur. The time value lost by NOT investing will be greater than the taxes you will pay on any gains. You may be able to employ a tax-loss harvesting strategy if any underlying assets lose value.
Concerning Form 8606, this document shows that the funds you converted were indeed post-tax; therefore, you do not owe any conversion taxes.

In Conclusion

Are you considering a Backdoor Roth Conversion? We strongly advise scheduling a meeting to go over the details of your Roth accounts before taking any concrete steps. Just click the button below!

About the Authors

  • Douglas Walters

    Doug is the Managing Partner of Walters Strategic Partners, LLC, a licensed Registered Investment Advisory firm. Doug is a licensed Certified Public Accountant (CPA) in the state of Florida and holds a Series 65 Investment Advisor Representative securities license. He is also a member of the AICPA. With over 28 years of experience as a CPA, he believes investment decisions should be based on decades of peer-reviewed research rather than relying on the latest “hot tip” from media outlets. This empirical evidence puts the science of investing to work for his clients.

  • Jose Joia

    Jose M. Joia is a Wealth Advisor at Walters Strategic Advisors, LLC. As a member of the team, Jose’s responsibilities involve comprehensive wealth management, planning and customer service. He has over 6 years of industry experience specializing in planning and solving unique issues his clients encounter. Jose has experience serving individual clients, business owners and non-profit organizations.