A Roth account is a popular option for IRA contributors, mainly because of its tax benefits.
While account holders save towards retirement, they also get to enjoy tax-free growth and withdrawals upon retiring.
Yet, a Roth IRA account can be limiting for most high-income earners such as physicians, due to the IRS income limit.
Based on the IRS Roth income guide, contributions are limited to about $138,000 for singles and $250,000 for married filing jointly.
In this case, the only other option to enjoy the Roth IRA benefits is through a Backdoor Roth.
Key Takeaways
- A Backdoor Roth enables high-income earners to enjoy the tax benefits of a Roth IRA account.
- Backdoor Roth is achieved by making a non-deductible contribution to a Traditional IRA and converting to a Roth IRA.
- Contributors using this strategy must report their taxes using Form 8606
- Every Backdoor Roth contributor should take note of the Pro-Rata rule, which requires a part of your conversion to be taxed based on certain requirements.
Table of Contents
What Is a Backdoor Roth?
A Backdoor Roth IRA contribution is a tax strategy that allows individuals who exceed the income limits to take advantage of the tax benefits of a Roth account by contributing directly to a Roth IRA.
The procedure follows two steps:
First, the individual makes a non-deductible contribution to a traditional IRA, which is allowed regardless of income.
Shortly after this, they can convert that amount from a Traditional IRA to a Roth IRA.
Considering the non-deductible nature of the contribution, only the earnings would be subject to taxes during conversion, if there are any.
Completing Your Form 8606
While Backdoor Roth IRA contributions require conversion from a Traditional Roth using a non-deductible contribution, the IRS requires anyone using this strategy to fill out Form 8606.
Besides being compliant with IRS regulations, filling out this form helps ensure that your non-deductible contributions are reported and that they won’t be taxed again upon withdrawal.
Key Sections of Form 8606
Before filling out Form 8606, it’s best to understand the three major sections and what each one requires.
- (Section I) Non-deductible Contributions to Traditional IRAs: This section tracks your non-deductible contribution for the current year. It also adds them to your prior year’s contributions to calculate your total basis in IRAs.
- (Section II) Conversions from Traditional, SEP, or SIMPLE IRAs to Roth IRAs: This section reports the amount converted to a Roth IRA and calculates the taxable portion of the conversion.
- (Section III) Distributions from Roth, SEP, and SIMPLE IRAs: This section is used to report distributions from Roth IRAs, ensuring that the distributions are correctly taxed (or not taxed, in the case of qualified distributions).
Five Steps to Report Form 8606
Step One: Gather the Necessary Information
Start by putting together all the pieces of information that could help you fill out your form. Some of the required details include:
- The amount contributed
- The date and nature of the contribution (non-deductible in this case)
- The date of conversion and the amount converted to Roth.
Also, download Form 8606 from the IRS website.
Step Two: Complete Part I
This part contains over eight lines. To fill them out, follow the instructions below.
- Line 1: Enter your total non-deductible contribution to Traditional IRAs for the year.
- Line 2: Fill in your total basis in Traditional IRAs. This is the amount of non-deductible contributions you have made in the previous years that haven’t been previously withdrawn or converted.
- Line 3: Add lines 1 and 2. This becomes your total basis for the year.
- Line 4: Enter the value of all your Traditional IRAs as of December 31st of the tax year, plus any outstanding rollover.
- Line 5: Fill in any distributions you took from Traditional IRAs during the year (other than conversions).
- Line 6: Add lines 4 and 5.
- Line 7: Divide line 3 by line 6. The amount you get is the percentage of your non-deductible contribution to your IRA.
- Line 8: Multiply line 7 by line 6 to determine the amount of non-deductible contribution.
Step Three: Complete Part II
This is the part where you should fill your Roth IRA conversions
- Line 16: Enter the amount you converted from Traditional, SEP, or SIMPLE IRAs to Roth IRAs.
- Line 17: Subtract line 8 from line 16. This is the amount of your conversion that is taxable.
- Line 18: Add the amount from line 8 (non-deductible contribution) and any taxable amount from line 17.
Step Four: Complete Part III
Finally, fill out the last part if applicable. If you took distributions from Roth IRAs, complete this section as per the instructions.
For a simple Backdoor Roth conversion without distributions, this section may not be applicable.
Step Five: Review and Attach to Tax Return
Once you’ve completed the required sections, carefully review the completed Form 8606 for accuracy.
Then attach it to your tax return (Form 1040) and submit it.
Things To Consider While Filling out Your Form 8606
Reporting your taxes can be tricky, which is why consulting with a professional is usually the best way to go.
However, if you intend to do your taxes yourself, here’s what you should know.
Understand Your Basis
Your basis refers to your current and previous year’s contributions.
Ensure you keep accurate records of these contributions since it’s relevant in calculating your taxable portions of conversions and withdrawals.
Accurate Reporting of Conversions
Try to avoid the mistake of delaying conversions from Traditional IRAs to Roth IRAs. This can increase the portions of your earnings that could be taxed.
To prevent this, ensure you convert your Traditional IRAs to Roth IRAs shortly after making the non-deductible contribution.
Pro-Rata Rule
If you have other pre-tax IRA balances, the IRS requires you to apply the Pro-Rata rule when converting to a Roth IRA.
This means that the conversion will be partly taxable based on the ratio of non-deductible contributions to the IRA balance.
But make sure you calculate carefully. Use the total balance of all your IRAs (excluding Roth IRAs) as of December 31st of the tax year when applying the Pro-Rata rule.
Handling Distribution
If you’re taking distributions from a Roth IRA, determine if they’re qualified (generally tax-free) or non-qualified (potentially taxable).
Understanding this helps you decide whether you need to fill out part III of Form 8060.
In addition, filling out part III requires accuracy. Ensure you’re entering all the distributions correctly to avoid penalties.
Filing Requirements
Usually, you’re required to attach your Form 8606 to your tax return, Form 1040, during submission. In some other cases, this attachment isn’t a requirement.
Whichever your situation, ensure you understand what’s required and follow through appropriately.
Seek Professional Advice
Tax laws and IRS rules can change, making them ordinarily impossible to keep up with.
However, a tax professional is always updated on these things and can guide you based on the current rules.
Besides, tax issues require accuracy, especially when dealing with concepts like Pro-Rata rules and multiple IRAs.
Consulting with a professional ensures you’re doing the right thing and avoiding future penalties.
6 Common Mistakes and Ways to Avoid Them
It’s almost expected for taxpayers to make mistakes when reporting taxes.
These mistakes can cause several issues, including penalties and double taxation. But the good thing is they can be avoided.
Here are six common mistakes people often make while handing in Form 8606, as well as tips to avoid them.
1. Incorrectly Reporting Non-deductible Contributions
Mistake: Failing to report non-deductible contributions correctly, either by not listing them or by incorrectly calculating the amounts.
How to Avoid: Keep thorough records of all non-deductible contributions made each year.
Also, double-check your entries on Form 8606 against your own records to ensure accuracy.
2. Misunderstanding the Pro-Rata Rule
Mistake: Not applying the Pro-Rata rule correctly, leading to incorrect calculation of taxable and nontaxable portions of conversions.
How to Avoid: Understand that the pro-rata rule requires you to consider all of your Traditional, SEP, and SIMPLE IRAs when calculating the taxable portion of a conversion.
Use the total value of these accounts as of the December 31st of the tax year.
3. Overlooking Previous Contributions
Mistake: Forgetting to include non-deductible contributions from previous years, leading to an inaccurate basis.
How to Avoid: Maintain a record of all non-deductible contributions. Ensure that each year’s Form 8606 carries forward the correct basis from prior years.
4. Incorrect Conversion Amount
Mistake: Reporting incorrect amounts for conversions from Traditional IRAs to Roth IRAs, either by underreporting the amounts converted.
How to Avoid: Verify the exact amount converted during the tax year and report it accurately on Form 8606. Keep the documentation of the conversion for reference.
5. Failing to File Form 8606 When Required
Mistake: Not filing Form 8606 when making non-deductible contributions or converting to a Roth IRA is a breach of the IRS requirements.
How to Avoid: Always file Form 8606 if you make any non-deductible contributions to a Traditional IRA or if you convert funds to a Roth IRA. Even if you’re not required to file a tax return, always submit Form 8606.
6. Improper Handling of Distributions
Mistake: Failing to properly report distributions from Roth IRAs, especially if they’re non-qualified and subject to taxes and penalties.
How to Avoid: Try to understand the rules for qualified and non-qualified distributions from Roth IRAs. Also, ensure that you’re reporting all distributions accurately.
Get the Best Financial Help from Physicians Thrive
Issues of tax reporting can get complicated quickly, especially if you don’t have the proper knowledge.
Yet it’s something that you must inevitably do at one point or the other.
While our guide is enough to get you started on reporting Form 8606 Backdoor Roth, it might not be all you need for the whole tax reporting process.
Seeking help from a professional financial advisor would be your best chance at scaling through.
If you ever need help planning your finances as a physician, give Physicians Thrive a shot. Just fill out this form, and our professionals will be in touch.
