Avoiding the Biggest Backdoor Roth IRA Conversion Mistake (It's Not What You Think)

The most common mistake I see with backdoor Roth conversions is unintentionally running afoul of the IRA aggregation rule, where having existing pre-tax IRA money messes up the expected tax outcome of a backdoor Roth IRA conversion. Most people would probably consider that the biggest mistake, since at its worst, close to 100% of a Roth conversion could be taxable, potentially at the highest tax brackets.

It's certainly not ideal, and I used to think it was the biggest mistake someone could make when executing a backdoor Roth IRA conversion, but I don't think that anymore. I believe this next mistake is truly the biggest and most devious when it comes to backdoor Roth conversions for three reasons:

It's easy to miss year after year and never know something went wrong.

The IRS likely won't catch and correct this mistake.

It results in double taxation, and you only have three years after the tax return due date to claim a refund.

That third reason is what makes it the biggest mistake in my mind. Unintentionally paying taxes on a conversion because of the aggregation rule is bad, but at least that money isn't being taxed twice. And if you don't catch this mistake within the refund window, you lose your opportunity to reclaim your overpaid taxes forever.

To me, the true biggest backdoor Roth IRA conversion mistake is improper tax reporting, specifically, incorrectly completing Form 8606.

In theory, a backdoor Roth conversion shouldn't incur any additional taxes. You make a non-deductible/after-tax contribution to a Traditional IRA and subsequently convert those funds to a Roth IRA. If you convert before any gains or earnings accrue, you've already paid taxes on all of that money and won't pay taxes on it again.

The problem arises because by default, the IRS assumes any and all Traditional IRA contributions are tax-deductible, even if you didn't take or weren't allowed to take a tax deduction on your contribution. In other words, if you made a non-deductible Traditional IRA contribution but didn't specifically report it as such, the IRS assumes you took a tax deduction even though you didn't. Now, your backdoor Roth conversion is subject to double-taxation: first on the initial non-deductible/after-tax contribution (this is correct), and again on the conversion amount the IRS assumes was all pre-tax (this is incorrect).

This is where Form 8606 comes in. Part I of Form 8606 records any non-deductible contributions to Traditional IRAs and ensures that any non-deductible contributions aren't taxed at withdrawal or conversion. However, many people fail to do this, which leads to the conversion amount being taxed a second time.

It's an easy mistake to make. Form 5498, which reports contributions made to IRAs, must be delivered by the IRA custodian by May 31st - well after the April 15th tax return due date. To make matters worse, some IRA custodians will issue a preliminary Form 5498 early in the year only showing IRA contributions through December 31st, before sending a finalized Form 5498 after April 15th. If you make an IRA contribution for the prior year between January 1st and April 15th but rely on the preliminary Form 5498 for your tax filing, you might unintentionally exclude your contribution from your Form 8606 reporting.

Although it's an information form not required for tax filing, a missing or preliminary Form 5498 can lead to a failure to report a non-deductible IRA contribution. And since IRA contributions are assumed to be pre-tax unless reported otherwise on Form 8606, that's how a forgotten non-deductible contribution would be treated.

The IRS can catch and correct clerical errors, and they do notify taxpayers of errors that result in refunds, but I've never seen the IRS issue a missing Form 8606 to record a non-deductible IRA contribution. I think the reason is two-fold. First, the actual "mistake" is made at the time of recording the contribution, and there would be no tax difference between filing and not filing Form 8606 to record a non-deductible contribution so there's nothing for the IRS to correct. Second, the event that results in additional taxes, the conversion, would pass any clerical checks in isolation since the math at that step is still correct. This is, of course, my assumption of why I haven't seen this correction.

Here's how this might look in practice:

Assume your tax rate is 25%. You make a $6,500 non-deductible contribution to your Traditional IRA for 2023 and subsequently perform a Roth conversion of the entire account. Here we assume that this is your only Traditional or pre-tax IRA, it had no money in it before the contribution, and there were no earnings or losses between the contribution and conversion, so the conversion amount is $6,500.

As you're preparing your tax return, you forget to download 2023's Form 5498 from your IRA custodian and don't report your $6,500 IRA contribution as non-deductible on Part I of Form 8606. You report making the $6,500 Roth conversion on Part II of Form 8606. As a result, $6,500 is incorrectly reported as taxable income, increasing your tax owed by $1,625.

Here's how it should look:

You make a $6,500 non-deductible contribution to your Traditional IRA for 2023 and subsequently perform a Roth conversion of the entire account. Again we assume that this is your only Traditional or pre-tax IRA, it had no money in it before the contribution, and there were no earnings or losses between the contribution and conversion, so the conversion amount is $6,500.

As you're preparing your tax return, you use 2023's Form 5498 to correctly report your $6,500 IRA contribution as non-deductible on Part I of Form 8606. You report making the $6,500 Roth conversion on Part II of Form 8606, which is a non-taxable conversion since Part I shows you had already paid taxes on that $6,500. You owe no additional taxes as a result.

What should I do if I discover I've made this mistake?

There's good news and bad news. The good news is that you can file amended tax returns to fix errors made in prior years and claim a refund of your overpaid taxes. The bad news is that the time limit to claim a refund is three years after the original tax filing deadline or two years after you paid the tax, whichever is later. In other words, if you always file and pay your taxes on time, you can't claim a refund for 2019 or any prior tax year (2019's returns were due on July 15th, 2020, which is more than three years before today). However, you still have time to claim a refund for 2020 and later.