It’s tax season at the OchoSinCoche household. As I started digging into my tax return for 2021, I quickly came to the realization that I had made a significant mistake with my backdoor Roth IRA contribution in 2021. Instead of making a non-taxable conversion, I had unexpected triggered a Roth conversion that was 96% taxable.
What is a Backdoor Roth IRA?
The Backdoor Roth IRA isn’t an official retirement account. Instead, it’s a process of getting around the income limits for contributing to a Roth IRA. The process involves making a non-deductible contribution to a traditional IRA and then immediately converting it into a Roth, generally paying little additional tax on earnings because of the short window between contributing and converting. It’s completely legal, but labeled a “backdoor” because it circumvents income limits.
To make the backdoor Roth IRA work, you first need to shelter all of your tax-deferred IRAs by rolling them into non-IRA plans, such as a 401k plan or similar. If you don’t, the backdoor Roth contribution triggers taxes on those IRAs. The IRS doesn’t view your traditional IRA accounts as separate, but as one big pot of money, and they will expect you to pay taxes proportionally on the rollover, something called the “pro rata” rule.
Over the years, I’ve rolled over old workplace 401k plans into traditional IRAs to avoid paying high fees. A few years ago, I set up a self-employed 401k plan with some self-employment income I had. I’ve used this self-employed 401k as the destination for our traditional IRA money. We don’t hit the income limits every year, but when we do, we’ve made backdoor Roth IRA contributions.
How I Messed It Up
I worried our income might exceed the income limits in 2021. In March, we made our contributions to our traditional IRAs, then immediately converted it to a Roth IRA. We had $.14 of earnings from interest gained in the week between when we made the contribution and when we rolled it over. Life was good.
In October, I rolled over my 401k from Startup Inc into a traditional rollover IRA account. And then I foolishly put off rolling it into my self-employed 401k plan. At the time, I didn’t realize that putting it off would mean that I had turned my backdoor Roth contribution for 2021 into a significant taxable event.
The damage? $5,755 of my $6,000 backdoor Roth contribution is taxable, and only $245 isn’t.
Because of my mistake, we’re paying an additional $1,734 in federal tax and $331 in state tax.
We’re in the 22% tax bracket, so why are we paying a 30% tax rate on the botched conversion ($1,734 / $5,755 = 30%)?
First, our investment income for the year means we’re paying an additional $218 in the net investment income tax.
Second, we were bumped into the child tax credit phaseout window, and the additional income means we lost $250 of the credit. This highlights why my decision to switch to Roth 401k contributions at the beginning of 2021 was such a bad idea. Luckily, I realized that quickly and switched back to traditional contributions. Our tax bill for 2021 would have been even more if I hadn’t realized my folly when I did.
Fixing My Mistake
I can’t do anything to fix the botched backdoor Roth conversion at this point. I needed to fix it by rolling the money into my self-employed 401k before December 31st, 2021, which I failed to do.
Luckily, Joe Manchin has my back and helped me out by holding back the Build Back Better bill. The bill would have killed the backdoor Roth by prohibiting the conversion of non-deductible traditional IRAs into Roth IRAs, the backbone of the backdoor Roth strategy. No puns intended.
In 2022, I can clean this up in two steps:
Step 1: Convert $5,755 from my traditional IRA into my Roth IRA. Because I botched things, I now have a basis in my traditional IRAs. I want to clear that out now before the rules for backdoor Roth IRAs close. I can do that by making another conversion of at least as much as my basis. Fingers crossed that Build Back Better, version 2 doesn’t kill the backdoor Roth retroactively to the start of 2022.
Step 2: Rollover the rest of my traditional IRA money into my self-employed 401k. This prevents my conversion in Step 1 from becoming another significant taxable event. This must be done by December 31st, 2022, but I’ll probably end up doing it shortly after Step 1.
Accidentally paying additional tax isn’t the end of the world. I’d choose paying too much tax over many other problems. And luckily, thanks to Manchin, I have a way to fix it in 2022. Without Manchin’s help, I *think* my fix would have been the same, except Step 1 would have been withdrawing the basis and paying the early withdrawal penalty on the earnings, which would have been small. Either that or continue filing Form 8606 to the end of time.
Can you see any holes in my logic on how to fix this? I’d love to hear your thoughts in the comments.