Is a Backdoor Roth Conversion Taxable?

A backdoor Roth conversion is a financial strategy used by high-income earners to contribute to a Roth IRA, even if their income exceeds direct contribution limits. Whether this conversion is a taxable event depends on an individual’s existing retirement accounts, meaning it can be tax-free, partially taxable, or fully taxable.

The process involves contributing money to a traditional IRA and then converting that amount to a Roth IRA. The taxability of this second step hinges on whether the individual holds other IRA funds that were funded with pre-tax dollars.

The Basis of a Tax-Free Conversion

A tax-free backdoor Roth conversion is based on a non-deductible contribution to the traditional IRA. This means the money you put into the account has already been taxed, and you do not receive a tax deduction for this contribution. This non-deductible contribution creates what is known as “basis” in your IRA, which is the amount of after-tax money in the account.

In the ideal scenario, this non-deductible contribution is the only money present across all of your traditional IRAs. You would make the contribution and then, before any earnings can accumulate, convert the entire amount to a Roth IRA. When the conversion consists solely of the after-tax basis and no other pre-tax funds exist in any traditional IRAs, the conversion is not a taxable event. Since you already paid income tax on the money, the IRS does not require you to pay tax on it again when it moves into a Roth IRA.

The Pro-Rata Rule Explained

The pro-rata rule is the primary reason a backdoor Roth conversion becomes a taxable event. This rule is triggered when an individual has a mix of after-tax (non-deductible) and pre-tax funds in their IRAs. For a Roth conversion, the IRS does not look at each IRA in isolation; instead, it views all of an individual’s traditional IRAs, SEP IRAs, and SIMPLE IRAs as a single, consolidated account. The total value of these accounts on December 31 is used for the calculation.

When you make a non-deductible contribution while also holding pre-tax balances, any amount you convert to a Roth IRA is deemed to be a proportional withdrawal from both the taxable (pre-tax) and non-taxable (after-tax) portions of your total aggregated IRA balance. You cannot simply choose to convert only the after-tax money.

Certain accounts are excluded from this aggregation. Your Roth IRAs are not included in the pro-rata calculation, and neither are workplace retirement plans such as 401(k)s, 403(b)s, and governmental 457(b) plans. This exclusion provides a planning opportunity, as some individuals might be able to roll pre-tax IRA funds into their current employer’s 401(k) plan, if the plan allows for it.

How to Calculate the Taxable Portion

Applying the pro-rata rule involves a calculation to determine what percentage of your Roth conversion is subject to income tax. First, you must identify your total basis, which is the sum of all non-deductible, after-tax contributions you have ever made to any of your traditional, SEP, or SIMPLE IRAs. Next, you need to determine the total value of all your traditional, SEP, and SIMPLE IRAs as of December 31 of the year in which the conversion took place. This total value includes all contributions and all accumulated earnings.

With these two figures, you can calculate the taxable portion of your conversion. The formula is to divide your total pre-tax IRA funds (total IRA value minus your basis) by the total value of all your IRAs. This gives you the percentage of your total IRA assets that is pre-tax, which you then multiply by the amount you converted to find the taxable amount.

For a practical example, an individual has a SEP IRA with a balance of $94,000, all of which is pre-tax money. They execute a backdoor Roth conversion by making a $6,000 non-deductible contribution to a new traditional IRA. As of December 31, their total IRA value across both accounts is $100,000, and they convert the $6,000.

Their basis is $6,000, and their pre-tax funds total $94,000. The pre-tax percentage is 94% ($94,000 / $100,000), so 94% of their $6,000 conversion, or $5,640, is a taxable distribution.

Reporting a Backdoor Roth Conversion

A backdoor Roth conversion must be reported to the IRS on Form 8606, Nondeductible IRAs. This form is filed along with your annual federal income tax return, Form 1040, for the year in which the conversion occurred. Failure to file Form 8606 can lead to penalties and the risk of the entire conversion amount being treated as taxable.

The form guides you through the pro-rata calculation. You will report your non-deductible contribution for the year and your total basis, which includes non-deductible contributions from previous years. The form then uses the total value of all your traditional, SEP, and SIMPLE IRAs as of December 31 and the total amount you converted to calculate the taxable and non-taxable portions.

Once the calculations on Form 8606 are complete, the resulting taxable amount is transferred to your main tax return. This amount is included in your gross income for the year and taxed at your ordinary income tax rate.