The backdoor Roth IRA is a clever strategy used to get the same benefits as direct Roth IRA contributions without the income limitations imposed by the IRS. But investors who aren't careful might find themselves paying additional taxes on their conversion.
That's especially true in 2020, when many people experienced big career changes and may have rolled over their workplace retirement accounts to an IRA. That can cause a big headache for those relying on the backdoor Roth IRA. Fortunately, there's a way to fix it.
How the backdoor Roth IRA works
The backdoor Roth IRA works because the IRS allows you to make non-deductible contributions to a traditional IRA if you're over the income limitation to qualify for a deductible contribution.
Those after-tax funds would usually sit in your IRA and grow tax-free. When you go to make a distribution from the IRA in retirement, the original contribution comes out tax-free, but you'll pay taxes on the earnings.
A backdoor Roth makes that IRA withdrawal shortly after the contribution, so you barely pay any taxes at all on the conversion to a Roth account. That net effect is very similar to a direct contribution to a Roth IRA.
Where the backdoor Roth goes wrong
If you already have a traditional IRA with contributions you've deducted or expect to deduct on your tax return, the backdoor Roth won't work out very well. The problem is the IRA aggregation rule.
The IRS considers all your funds in all your IRAs when determining the tax treatment of your distributions. It'll prorate your withdrawals, pre-tax, and after-tax funds based on the totals across all IRA accounts you own. That includes any pre-tax funds you might've rolled over from a workplace retirement account like a 401(k) into an IRA, as well as SEP IRAs and SIMPLE IRAs.
Importantly, the IRS considers the funds in an IRA on Dec. 31 of the year you make the Roth conversion, not at the time of the conversion. So, if you converted non-deductible IRA contributions to a Roth early in the year, and then you rolled over a traditional 401(k) to an IRA after the conversion, you'll still be subject to the aggregation rule.
For example, say you made a $6,000 non-deductible contribution to an IRA early in the year. You immediately converted those funds into a Roth. Over the summer, you got let go from your job, and you rolled over your $114,000 traditional 401(k) into an IRA. At the end of the year, you now have $114,000 in pre-tax funds in your IRA and $6,000 of after-tax fund contributions.
Of the $6,000 distribution you took when you made the Roth contribution, 95% of it will be taxable at your marginal tax rate. That's on top of the taxes you paid on the $6,000 non-deductible contribution to your traditional IRA.
How to fix it if you messed up
If you rolled over a workplace retirement account or somehow ended up with pre-tax funds in a traditional IRA after your backdoor Roth conversion, there's still time to fix it.
If you got a new job with a 401(k) or other retirement plan, you may be able to roll your traditional IRA into your new 401(k). You'll need to contact your HR department and get started on the process as soon as possible. You need the funds out of your IRA before Dec. 31 and it takes several days to process, so don't delay.
If you didn't get a new job, but you did some side hustles or contract work this year, you're eligible to open your own 401(k). Most discount brokerages offer a free solo 401(k) plan that's pretty easy to set up. Ideally, the institution holding your IRA also offers a solo 401(k) and will allow you to rollover your IRA into the plan, which will make things a bit easier. Once you get a solo 401(k) plan set up, you just have to fill out another form to rollover your IRA into the solo 401(k).
If you don't have either option at your disposal, then you're out of luck. You'll have to pay extra taxes this year.
It's not like the tax advantage is completely lost, though. You'll still have some after-tax funds in your traditional IRA that you won't have to pay taxes on when you withdraw them. But in the immediate term, it limits your ability to use the backdoor Roth IRA strategy to its full advantage.