How to Do a Backdoor Roth IRA With a SEP IRA
For self-employed individuals, a SEP IRA can interfere with a backdoor Roth strategy. Understand the steps to manage your retirement accounts for a clean conversion.
A backdoor Roth IRA is a strategy used by high-income earners to contribute to a Roth IRA, even if their income exceeds direct contribution limits. The process involves contributing to a traditional IRA and then converting it to a Roth IRA. For self-employed individuals and small business owners, a Simplified Employee Pension (SEP) IRA is a common retirement savings vehicle. The presence of a SEP IRA introduces specific tax considerations that can complicate the backdoor Roth IRA process.
The IRA Aggregation and Pro-Rata Rules
The primary obstacle to performing a backdoor Roth IRA when you have a SEP IRA lies in two interconnected IRS regulations: the IRA aggregation rule and the pro-rata rule. The IRA aggregation rule requires that for a Roth conversion, the IRS treats all of an individual’s traditional, SIMPLE, and SEP IRAs as a single, consolidated account. This aggregation of accounts directly triggers the pro-rata rule.
The pro-rata rule dictates that any conversion from a traditional IRA to a Roth IRA will be a proportional mix of pre-tax and after-tax funds, based on the ratio of these funds across all your aggregated IRAs. Since SEP IRA contributions are made with pre-tax dollars, a large SEP IRA balance can result in a significant tax liability. For example, if an individual has $94,000 in a SEP IRA and contributes $6,000 to a non-deductible traditional IRA to convert, the IRS views the total IRA balance as $100,000.
In this scenario, the after-tax portion is only $6,000, or 6% of the total. Consequently, when the $6,000 is converted to a Roth IRA, only 6% of that amount ($360) is a tax-free conversion of the after-tax contribution. The remaining 94% ($5,640) is deemed a conversion of pre-tax funds and is subject to ordinary income tax.
The value of all traditional, SEP, and SIMPLE IRAs on December 31st of the year the conversion is made is used for the pro-rata calculation. The existence of any pre-tax funds in these accounts at the end of the year will lead to a taxable event upon conversion, making it necessary to address the SEP IRA balance before proceeding.
Resolving the SEP IRA Conflict
The most common method for resolving the conflict is to move the SEP IRA funds into a retirement plan that is not subject to the IRA aggregation rule. Employer-sponsored retirement plans, such as 401(k)s, 403(b)s, and governmental 457(b)s, are excluded from the pro-rata calculation for Roth conversions. For self-employed individuals or small business owners, the most direct solution is to establish and use a Solo 401(k).
A Solo 401(k) is a retirement plan designed for a self-employed individual with no employees, other than a spouse. By opening a Solo 401(k), you create a new retirement vehicle that can accept a rollover from your SEP IRA.
The process involves rolling over the entire pre-tax balance from the SEP IRA into the newly established Solo 401(k). Once this rollover is complete, the total balance of your traditional, SEP, and SIMPLE IRAs for the pro-rata calculation becomes zero. This maneuver isolates the non-deductible contribution you will make to a traditional IRA, ensuring that when you convert it to a Roth IRA, the conversion is treated as after-tax money and is a non-taxable event.
Executing the Backdoor Roth IRA Strategy
The first step is to establish a Solo 401(k) plan. This involves selecting a financial institution that offers Solo 401(k) plans and completing the paperwork to open the account. You must ensure the plan documents for your new Solo 401(k) permit rollovers from other retirement accounts, such as a SEP IRA.
Once the Solo 401(k) is established, initiate a direct rollover of the entire balance from your SEP IRA to the new Solo 401(k). A direct rollover, where funds are transferred directly between custodians, is preferable to an indirect rollover to avoid potential tax withholding and the 60-day rollover rule.
With the SEP IRA balance now housed in the Solo 401(k), you can proceed with funding a traditional IRA. You will make a non-deductible contribution to either a new or an existing traditional IRA. For 2025, the limit is $7,000, with an additional $1,000 catch-up contribution allowed for individuals age 50 and over.
The final step is to convert the traditional IRA to a Roth IRA. After the non-deductible contribution has settled in the traditional IRA, you will contact your IRA custodian to process the conversion of the full balance to your Roth IRA.
Tax Reporting Requirements
Properly documenting the backdoor Roth IRA process is done using IRS Form 8606, Nondeductible IRAs, which is filed with your annual income tax return. Failure to file Form 8606 can result in a penalty.
Part I of Form 8606 is used to report your non-deductible contributions to a traditional IRA. This establishes your basis in the traditional IRA, which is the amount of after-tax money in the account. It is important to keep a copy of Form 8606 for your records, as it tracks your basis over time.
Part II of Form 8606 is where you report the conversion of your traditional IRA to a Roth IRA. This section of the form walks you through the pro-rata calculation to determine the taxable amount of your conversion. When completing Part II, the form will show that the entire amount of your conversion is non-taxable because your basis in the traditional IRA is equal to the amount you converted.
You will also receive Form 1099-R from your financial institution showing a distribution from your traditional IRA and Form 5498 showing the contribution to your Roth IRA. These forms are used to help complete Form 8606.