Backdoor Roth conversion

[Elizabeth N]

I have a client that does a backdoor Roth every year.

In 2021, he contributed $7k to a traditional IRA in April and designated it for 2020. He contributed to a 2021 traditional IRA in August of 2021 another $7k. So $14 was contributed in 2021 traditional IRA but $7k of it was designated for 2020.

He then converted both to Roth IRA in 2021. So for 2021 he received a 1099R showing a $14k distribution from traditional IRA, and 5498 for 2021 showing a $14k roth  conversion in box 3.

I advised that only $7k per year conversion allowed for Roth, so the additional $7k is taxable as a regular distribution. In addition, he over contributed to the 2021 Roth and incurred penalty.

Both he and his broker insist that there is no taxable event here.  Inputs into Lacerte plus reading of the tax regs seem to confirm my position but I want to make sure I'm not missing something.

This is not a mega backdoor Roth, which is the only thing I could think of that might allow it.

Thank you.

[qbteachmt]

"I advised that only $7k per year conversion allowed for Roth"

Whoever told you that does not know the rules and should be corrected by you, or you should start using a different mentor. There is no limit for conversions. Limits applies to Contributions.

"Both he and his broker insist that there is no taxable event here."

The magic for a Backdoor Roth to work, is because any funds in the account(s) of that same type are Basis (never tax deducted and no earnings). Otherwise, any amount converted (which really is all you are doing with backdoor) is taxable on a pro rata basis. If your taxpayer had put all the money into the Trad IRA at once and immediately converted it to Roth, and has nothing else in any similar tax-deferred type of account (as per the listed account types on the Form 8606), then there would be no taxable event.

Your taxpayer had a delay in the contributions. If there are any earnings against the earlier amount, or against the total prior to the conversion, then these amounts are the taxable amounts, as pro rata to the amount converted.

"I advised that only $7k per year conversion allowed for Roth," <== not correct

"so the additional $7k is taxable as a regular distribution." <== applies anyway, as a Conversion is always a Distribution. The issue is how the Distribution is treated. A Backdoor Roth = an immediate distribution as direct transfer, at the time of contribution and conversion being the same date, to avoid having taxable earnings and to avoid triggering any required withholding.

"In addition, he over contributed to the 2021 Roth and incurred penalty."

That can be dealt with by a Corrective Distribution. You would then report and pay excise tax of 6% on those earnings and do not roll/convert that amount.

[qbteachmt]

Oh, wait: you don't have any Roth Contribution in any of this story. There is no over-contribution if the only funds were from Conversion. There would be no corrective distribution needed.

[Elizabeth N]

thank you for that, I had my terms mixed up.

I need to look at my Lacerte inputs, I think I'm missing basis info because it wants to tax some of it which seemed incorrect so I wanted to ask.

It's my first year using this program and I'm not familiar with where things go.

Appreciate the prompt and helpful response

[qbteachmt · Accepted solution]

"because it wants to tax some of it which seemed incorrect"

Yes, your taxpayer will be paying taxes on the earnings amount, which will be seen as a pro rata percentage.

Invest $7k into a Trad IRA account as nondeductible on the tax form, and let's assume it grows at 10% APR ($350) and 6 months later, invest another $7k and on that same date, convert all of this to Roth.

Assume there are no other funds in accounts that fall in the same category as Trad IRA.

The math is: $350 earnings (never taxed)/$14,350 basis (post-tax) = 2.44% taxable. If there are other funds in Trad IRA or similar account type(s), then the math on any conversion changes accordingly.

A "backdoor" is just a conversion done on Basis and done so quickly it avoids having earnings. At least, that's the plan.