Split-Year Backdoor Roth IRAs

Can I contribute to a Roth IRA? Can I do a Backdoor Roth IRA? These are two questions I often hear as a tax-focused financial planner.

Perhaps you find yourself preparing your 2020 tax return in early April 2021. You have not contributed anything to a traditional IRA or a Roth IRA yet for 2020. Do you have time to perhaps do a Roth IRA or a Backdoor Roth IRA? The answer is, “Absolutely!” if you have the right facts in place. Let’s discuss a comprehensive example:

Example 1: Jack is single, 35 years old, participates in a 401(k) at work, and has self-prepared his 2020 tax return but not yet filed it. It is April 9, 2021, and his tax-return software indicates that he does not qualify for a Roth IRA, as his modified adjusted gross income for 2020 is $150,000. Jack has no traditional IRAs, SEP IRAs, or SIMPLE IRAs. Jack just learned about the existence of the Backdoor Roth IRA. 

What can Jack do? Can he do a Backdoor Roth IRA for 2020? The answer is, Yes! 

First, Jack should, by April 15, 2021, make a traditional, non-deductible IRA contribution of $6,000. When he does this, he should designate the contribution as being for 2020. With his soon-to-be-filed 2020 federal income tax return, he should file a Form 8606 which will report the $6,000 traditional, non-deductible IRA contribution. Easy enough. 

Assuming Jack contributed to his 2020 traditional, non-deductible IRA in April 2021, in May of 2021 Jack should convert the entire balance in his traditional IRA to a Roth IRA. Third, he should ensure he has no balance in traditional IRAs/SEP IRAs/SIMPLE IRAs as of December 31, 2021. 

Jack can also do a Backdoor Roth IRA for 2021, which may be advisable if (a) his modified adjusted gross income exceeds the Roth IRA contribution thresholds and (b) he will have no balance in traditional IRAs/SEP IRAs/SIMPLE IRAs as of December 31, 2021. 

Assume Jack makes a traditional, non-deductible contribution to an IRA for 2021 on June 1, 2021, and on July 2, 2021, he converts the amounts in the traditional IRA to a Roth IRA. Further assume (a) the amounts converted in May and July were $6,001 and $6,002, respectively, and (b) Jack has no balance in traditional IRAs/SEP IRAs/SIMPLE IRAs as of December 31, 2021. 

When Jack files his 2021 tax return, Page 1 of his Form 8606 should look like this:

Page 2 (reporting the 2021 Roth IRA conversions) of the Form 8606 should look like this:

Post Tax Return Filing Split-Year Backdoor Roth IRA

Example 2: Jim is single, 35 years old, participates in a 401(k) at work, and has self-prepared his 2020 tax return and filed it on March 15, 2021. Jim’s modified adjusted gross income for 2020 is $150,000. Jim has no traditional IRAs, SEP IRAs, or SIMPLE IRAs. It is April 9, 2021 and Jim just learned about the existence of the Backdoor Roth IRA. 

Can Jim still do a Backdoor Roth IRA for 2020? Absolutely!

First, Jim should, by April 15, 2021, make a traditional, non-deductible IRA contribution of $6,000. When he does this, he should designate the contribution as being for 2020. So far, everything is the same as Example 1.

But here is where things change. Jim should also, by April 15, 2021, file a standalone Form 8606 with the IRS and be sure to sign the form on page 2. The Form 8606 will report the contribution to the traditional, non-deductible IRA. Jim will have to paper file the Form 8606 and mail it to the IRS Service Center that he would mail his Form 1040 to (if he were to paper file his Form 1040). 

Jim could then convert the traditional IRA to a Roth IRA to successfully complete the Backdoor Roth IRA. He should also ensure he had no balance in a traditional IRA, SEP IRA, or SIMPLE IRA on December 31, 2021. 

Advanced Split-Year Backdoor Roth IRA

Example 3: Jill is married to Joe, 35 years old, participates in a 401(k) at work, and has self-prepared their 2020 tax return but not yet filed it. Jill and Joe’s modified adjusted gross income for 2020 is $250,000. Jill has a traditional IRA with a balance of $100,000 (and no previous non-deductible contributions). It is April 9, 2021 and Jill just learned about the existence of the Backdoor Roth IRA. 

Jill’s example is a bit more challenging than Jack and Jim’s previous example. Yes, it is possible that Jill could successfully complete a Backdoor Roth IRA for 2020. But it involves much more execution risk – the risk that the proper steps will not be completed in time. While taxpayers engaging in any sort of tax planning should consider engaging professional assistance, Jill is in a position where that is even more so the case. 

Here is how Jill could successfully execute a Backdoor Roth IRA for 2020. Jill should go to her workplace benefits website and download and review the “Summary Plan Description” for the 401(k) plan (sometimes initialized “SPD”). 

It may be the case that Jill’s workplace 401(k) plan will accept a roll-in of her traditional IRA. Many 401(k)s do, but many do not. Some plans will only accept roll-ins of other qualified plans (401(k)s, 403(b)s, etc.), and some plans will only accept roll-ins of qualified plans and so-called “conduit IRAs” i.e., IRAs that consist only of money that was formerly in a qualified plan. However, there are some plans that will accept roll-ins of both old qualified plans and any type of traditional IRA (though note that in all events 401(k) plans cannot accept roll-ins of amounts representing non-deductible IRA contributions).

If Jill’s workplace 401(k) plan will accept a roll-in of the $100,000 traditional IRA, then Jill could transfer (in a direct trustee-to-trustee transfer) her traditional IRA (other than the amount of any nondeductible contributions, including a $6,000 2020 contribution) to the 401(k). If she fails to do that by December 31, 2021, then any Backdoor Roth IRA would be very tax inefficient (and unavisable) – you can read more here in the “Jennifer” example. 

This is one reason I say that there is “execution risk” – perhaps Jill does the “Backdoor Roth IRA” steps but neglects the transfer of the old traditional IRA to the 401(k) until after December 31, 2021. If that happens, Jill’s Backdoor Roth IRA will now be very tax inefficient.

Some might say “couldn’t Jill start a side hustle, open a Solo 401(k) for it, and then roll the traditional IRA into the Solo 401(k)?” To my mind, that is a dangerous path. Jill’s side hustle might not rise to the level of a trade or business for tax purposes. If it does not, then it is not eligible to have a Solo 401(k). Any transfer of a traditional IRA to a plan that does not qualify as either an IRA, 401(k), 403(b), or similar plan is simply a taxable distribution subject to full income tax and a 10 percent early withdrawal penalty. Ouch!!!

Jill should not over think it. If she can easily roll her old traditional IRA into her workplace 401(k), then she should consider doing so and doing a Backdoor Roth IRA. But if she cannot, then fine, there are plenty of other ways to become financially independent and/or achieve retirement planning goals. Not having the Backdoor Roth IRA tool available is no killer to her future plans and goals. 

Note further that if Jill’s balance was in a SIMPLE IRA that was less than 2 years old, she could not roll the SIMPLE IRA into anything other than a SIMPLE IRA for the first two years of her SIMPLE IRA’s existence without incurring a 25% penalty.

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This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.