How to Track Your Backdoor Roth IRA Basis

The backdoor Roth IRA is a financial strategy for high-income earners who exceed the income limits for direct Roth IRA contributions. It involves contributing to a Traditional IRA and then converting those funds to a Roth IRA. The key to this strategy is “basis,” which represents the amount of money in your IRA that has already been subjected to income tax.

When you contribute with after-tax dollars, you create basis. This allows the subsequent conversion to a Roth IRA to be a non-taxable event, as the IRS does not tax the same money twice. Without diligent tracking and reporting, you risk paying unnecessary taxes on the funds you convert.

Establishing Your Nondeductible IRA Basis

IRA basis is the total of all after-tax, or nondeductible, contributions made to your Traditional IRAs. This is money on which you have already paid income tax, so it will not be taxed again when withdrawn or converted. This basis is created when you contribute funds to a Traditional IRA but do not claim a tax deduction for that contribution.

For individuals whose income is too high to qualify for a deductible Traditional IRA contribution, any contribution they make is by default a nondeductible one. This action establishes basis in the account. For example, if you contribute $7,000 to a Traditional IRA and do not deduct it on your tax return, you have created a $7,000 basis. This distinguishes it from pre-tax contributions, which have not yet been taxed.

You must inform the IRS of this nondeductible contribution by filing Form 8606, Nondeductible IRAs. Filing this form is how you officially record your after-tax contributions and track your cumulative basis. Filing Form 8606 for the year of the contribution is a necessary step, even if you convert the funds immediately. This documentation ensures the IRS recognizes that the converted funds are after-tax and should not be included in your taxable income.

The Pro-Rata Rule and Its Impact on Basis

The pro-rata rule can complicate the backdoor Roth IRA strategy if you hold other IRA assets. For tax purposes, the IRS applies an aggregation rule, which combines all of your Traditional, SEP, and SIMPLE IRAs into a single account when determining the taxability of a conversion. This rule prevents you from selectively converting only your after-tax basis if you also have pre-tax funds in any of these accounts.

When you convert funds from a Traditional IRA to a Roth IRA, the pro-rata rule dictates that the conversion will consist of a proportional mix of your after-tax (basis) and pre-tax funds. You cannot simply choose to convert only the nondeductible contribution. The calculation requires you to determine what percentage of your total IRA assets is basis, and then apply that percentage to your conversion to find the tax-free portion.

For example, imagine you make a $7,000 nondeductible contribution, creating a $7,000 basis. You also have a Rollover IRA with a pre-tax balance of $93,000. Due to the aggregation rule, your total IRA assets are considered to be $100,000, and your basis represents 7% of your total IRA value ($7,000 / $100,000).

If you then convert $7,000 to a Roth IRA, the pro-rata rule applies. Only 7% of that conversion, or $490, is the tax-free return of your basis. The remaining 93%, or $6,510, is treated as a taxable distribution and must be included in your ordinary income. This demonstrates how pre-tax IRA funds can lead to an unexpected tax liability. To execute a completely tax-free backdoor Roth IRA, you must have a zero balance across all Traditional, SEP, and SIMPLE IRAs by December 31 of the conversion year.

Required Information for Reporting on Form 8606

Accurate reporting on IRS Form 8606 requires gathering specific financial information. To complete the form, you must collect several data points:

• The total value of all your Traditional, SEP, and SIMPLE IRAs as of December 31 of the tax year.
• Your total basis in Traditional IRAs from prior years, found on line 14 of the previous year’s Form 8606.
• The amount of nondeductible contributions made for the current tax year.
• The total amount of funds converted to Roth IRAs during the year, which is reported on Form 1099-R.
• Any other distributions taken from your Traditional IRAs during the year.

Part I of the form is where you report your nondeductible contributions for the current year. You will enter this amount and add it to your existing basis from prior years to calculate your total available basis.

Part II of the form addresses the conversion and is where the pro-rata calculation is formally executed. The form uses your total basis, total IRA value, and the amount converted to determine the taxable portion of your conversion. This taxable amount is then reported on your Form 1040.

The Post-Conversion Basis

Once the conversion is complete and reported, the nature of your basis changes. The portion of the converted amount that was your original after-tax basis becomes contribution basis in the Roth IRA. This money can be withdrawn from the Roth IRA at any time, free of taxes and penalties, as if it were a direct contribution.

The taxable part of the conversion also becomes contribution basis in the Roth IRA after you pay the income tax. This combined basis can be withdrawn tax-free. However, a separate timing rule applies to converted funds that can introduce a penalty.

Each Roth conversion is subject to its own five-year holding period. If you withdraw any converted principal within five years of the conversion date, you may be subject to a 10% early withdrawal penalty, unless you are over age 59½ or qualify for another exception. This penalty applies only to the early withdrawal of converted amounts; the withdrawal itself is not subject to income tax. This five-year clock is calculated independently for each conversion you make, so tracking the date of each transaction is necessary to avoid potential penalties.