In this episode of ThimbleberryU, we dive into a common and costly mistake that often undermines the effectiveness of the backdoor Roth IRA strategy. We begin by establishing that the strategy itself is sound—used by high-income earners to legally sidestep income limits on Roth IRA contributions—but the pitfall lies in the tax return process, particularly in how the transaction is reported to the IRS.
We walk through how the strategy works: First, an individual makes a non-deductible contribution to a traditional IRA. Then, they convert those funds to a Roth IRA. The key here is that the contribution was already taxed, so the conversion should be non-taxable. The mistake happens when this sequence isn’t reported properly. We discuss how custodians like brokerage firms don’t know your tax strategy or income limits and cannot flag these issues for the IRS. So, if you're not proactively involved, you risk the IRS treating the conversion as fully taxable.
We unpack the three IRS forms involved: Form 1099-R (reports the conversion but not the tax status), Form 5498 (shows the IRA contribution but often arrives too late to help with timely tax filing), and most importantly, Form 8606 (tells the IRS the contribution was non-deductible and prevents double taxation). We emphasize that most errors occur because Form 8606 is either filed incorrectly or not filed at all. Without it, the IRS assumes your entire IRA is pre-tax, meaning future withdrawals will be fully taxed—even if you already paid taxes on that money.
Using a real-world example, we show how someone like “Jill” can end up paying taxes and penalties she didn’t owe, all because her CPA didn’t receive the full picture. This reinforces the importance of owning the communication and documentation process. We stress the need for record-keeping, proactively communicating with your CPA, and double-checking your return to ensure Form 8606 is present and correct.
In closing, we make it clear: the IRS isn’t malicious here—they can only go by what's filed. It's up to each of us to ensure our tax reporting matches our financial strategy. If you're going to use the backdoor Roth, you need to take responsibility for the reporting piece or work with an advisor who helps manage that process effectively.
ThimbleberryU 142 - The Tax Return Mistake That Undermines a Backdoor Roth Strategy
Speakers: Jon Gay & Amy Walls
[Music Playing]
Jon Gay (00:08):
Welcome back to ThimbleberryU. I'm Jon Jag Gay, joined as always by Amy Walls from Thimbleberry Financial. Hello, Amy.
Amy Walls (00:13):
Hi, Jag.
Jon Gay (00:14):
Today we're going to dig into something that can sound simple, but this can go sideways so fast: tax returns and the backdoor Roth IRA. Amy, why is this such a recurring issue?
Amy Walls (00:25):
Well, it depends. My next favorite words are great question with you, but great question. I think the reason is people often expect their tax return to just reflect what happened, and that their tax documents will just reflect what happened.
It's kind of a situation where a lot of people kind of go on autopilot and I just take these forms and plug things in and I'm done, or plug them in by handing them to the CPA.
Jon Gay (00:55):
And they don't want to be bothered by the hassle with them, just get this over with.
Amy Walls (00:59):
Yeah. But in reality, what happens is the IRS only knows from you what the tax return shows, and it's surprisingly easy that key pieces of information that paint the whole picture are left out. So, with backdoor Roths, this usually results in something being taxed twice, meaning the same dollars taxed twice, and people not realizing it later or never realizing it.
And it's not the backdoor Roth strategy that's the problem, the tax return and the preparation of the tax return is where this goes wrong.
Jon Gay (01:41):
Well, let me just back up for a second because I know we've talked about this in previous episodes, but in case a listener isn't familiar with the term or the strategy, can you explain what the backdoor Roth IRA is?
Amy Walls (01:51):
Absolutely, and I'll do this at somewhat a high level knowing that we have lots of episodes on this. The backdoor Roth strategy is a workaround for high income earners who are not eligible because of their income to contribute to a Roth IRA directly. So, instead, what they are able to do is make a non-deductible contribution to a traditional IRA. That's step one.
And step two, they then convert that contribution, the money in that traditional IRA into a Roth IRA. And if done correctly, the conversion should be mostly or fully non-taxable because they already paid taxes, if you will, on the money that was put in as a contribution.
Jon Gay (02:42):
Alright, got it. So, if it's such a smart strategy, where does the breakdown happen?
Amy Walls (02:47):
It's all about how it gets reported on the tax return and on the tax forms. Sorry listeners, I'm going to be as simple as I can be on this.
Jon Gay (02:55):
That's fine by me.
Amy Walls (02:57):
But it may not feel simple. First, when you make an IRA contribution, it gets reported on form 5498 by the custodian of the account. Forms 5498 do not typically come out until May of the next tax year.
Jon Gay (03:20):
Well, that's not helpful.
Amy Walls (03:21):
There are reasons, but yes, that is problem number one. When we file taxes by April 15th, the tax form showing that you made a contribution doesn't come out till May. So, right there, there is something that anybody who's contributing has to keep track of to tell their CPA.
So, now, we've contributed, we do a conversion. The conversion shows up on form 1099R, which does get sent to the taxpayer and the IRS at the beginning of each year in time for tax preparation. But that form, the 1099R does not say whether the money has already been taxed. It doesn't indicate what the tax status is just simply that a transaction occurred.
The part that tells the IRS, “Hey, I already paid taxes on this,” is a form that gets filed with the tax return, it can also be filed separately, it's form 8606. And most of the time when we see issues with this, it is because form 8606 didn't get filed or the CPA didn't have all of the information to fill it out correctly.
Jon Gay (04:36):
We're throwing out a lot of numbers of different forms here, Amy, but I think the underlying piece here is communicate, communicate, over communicate with your CPA and your team.
Amy Walls (04:45):
And take notes during the year. We've talked about this before. Keep a list during the year of your taxable transactions. And if you've got a good advisor, they're going to be reminding you this is something you are responsible for telling your CPA.
Jon Gay (05:01):
So, three forms you've got to know: 1099R, 5498, and 8606. What shows up on each form and what doesn't?
Amy Walls (05:09):
I'm going to start with form 1099R because that's the first one that's going to come in the mail or via email. So, form 1099R reports that money was distributed from the traditional IRA, but it doesn't say whether that money had already been taxed. Because the custodian doesn't know because that's a tax return question and an income question. So, there's no way the custodian will ever know the answer to that question.
And it will generally look like it's fully taxable income unless it's paired with other information. And most CPAs will default to if you're making an IRA contribution, you mean to be deducting it. And so, that's kind of just the default stance, is any traditional IRA contribution is deductible. So, that's probably where they started and why that 1099R is going to get treated as being taxable.
Jon Gay (06:10):
So, you got to be specific and say this is a non-deductible contribution.
Amy Walls (06:13):
Yes. And that leads us to form 5498 that comes out after taxes have been filed. So, CPAs aren't going to ask for it. And this is what says the IRA contribution was made. And even if you happen to somehow get one early and give it to your CPA, it doesn't say whether the contribution was intended to be deductible or non-deductible because the custodian doesn't know for the same reasons we just said.
Because of your income, because there's income limits, because they don't know your plan or your strategy, it can change. If your financial situation changed during the year, let's say somebody has contributed not for a backdoor Roth, but they were under the income limits to make a deductible IRA contribution, they qualified to do that, they did it, and then guess what? Their situation changes and now they've made an IRA contribution (that) they're no longer eligible to have made.
So, we can undo that (not to get messy here) or guess what? Now, we just tell the CPA, “Hey, make that non-deductible.” And it fixes the issue. So, the third form, again form 8606, this is the one that ties this all together for the IRS. It tells the IRS that you made a non-deductible contribution, and it shows your basis.
So, I'm going to segue for a quick second (my family might yell, “Squirrel” at me at this point), but why this is important, this deductible, non-deductible that we haven't talked about — is if you make a non-deductible contribution to an IRA, you always want to report that on form 8606.
Because let's say we're leaving the money in the IRA, and you've got some pre-tax money in there, maybe you rolled over a 401(k) or a 403(b) into this IRA and you've been making contributions — if you don't fill out form 8606, what happens is when you go to take distributions 30, 40 years down the line, the IRS is going to say all of this money is pre-tax money. The only way they know you put after-tax money in that is not supposed to be taxed again, is the completion of form 8606.
Jon Gay (08:31):
And correct me if I'm wrong here, but they could say you owe taxes on what went in as well as any growth at that point.
Amy Walls (08:37):
You're always going to owe taxes on the growth, but what you're trying to do is avoid paying taxes again on the basis.
Jon Gay (08:43):
Got it, okay.
Amy Walls (08:44):
In the form of the non-deductible. So, this is what saves your bacon and it's a good idea to complete it each year based on what you did, rather than saying, “Hey, we'll just compile this all later on and like fix this” and the memory, and if you've switched custodians, that's a mess that you probably will never be able to puzzle back together.
Jon Gay (09:04):
Saves your bacon, your cheddar, your dinero, any term you want to use. So, if I understand you right Amy, if someone doesn't know to file that 8606 form, they could pay that tax again on money they've already paid taxes on.
Amy Walls (09:16):
Imagine you make non-deductible contributions of $7,000 for 20 years, and obviously, that amount goes up, but now you have $140,000 in basis in this account, and as it comes out, I know I'd prefer not to pay taxes on that if I already did. I think you probably would, and I'm guessing our listeners would. So, the way to avoid that is filling out form 8606.
Jon Gay (09:47):
Alright, Amy, we've talked a lot about forms and concepts. Let's cement this for our listeners, with a real-world example.
Amy Walls (09:53):
Alright, so we'll talk about someone named Jill. She makes a $7,000 non-deductible traditional IRA contribution. Let's say she makes that in March of 2025. She converts it to a Roth IRA about a week later. Didn't have time for growth, it wasn't even invested, can kind of go straight across.
She gives her CPA in the early months of 2026, her 1099R that shows that $7,000 conversion. The CPA not having any other information to go off of, says, “Yeah, that was a normal IRA withdrawal and reports it as a distribution out of her IRA.”
Now, let's also say that Jill is 45-years-old. Not only is it taxable, but she's going to have penalties for early withdrawal, because the story isn't clear. But here we have it as a conversion, that avoids the penalty. And so, basically, CPA fills out the forms and this is a fully taxable transaction.
CPA doesn't have all the information, doesn't file form 8606. Jill has paid taxes again on that $7,000 on her 2025 tax return after she paid taxes through her withholdings on that $7,000. So, she had the income come in, now she's contributed and then converted it. She's paid taxes a second time and she's out of pocket money that was intended not to be taxed.
Jon Gay (11:46):
And again, it goes back to what we've been saying, Amy, which is, a tax preparer, or a CPA can only use the information that's been given to them. They're not mind readers. So, what is the right way to make sure this gets reported properly?
Amy Walls (11:58):
Jag, I'm going to say one thing before I answer your question. It might be easy to say, “Well gosh, if the system is this broken, why aren't we fixing it?” And I think it's important to note that the system isn't technically broken, it's not set up to catch this nuance where there's choice a taxpayer can make.
So, we also need to keep in mind that up until fairly recently, this backdoor Roth strategy was a loophole in the tax code that was allowed. Now, it's written in, but the more people use this strategy, the less money the IRS gets. So, they don't want to fix this, they want people to keep making the mistakes.
Jon Gay (12:41):
Fair point.
Amy Walls (12:42):
So, to your question though, what's the right way to make sure this gets reported? One, keep your own records. Know whether your IRA contributions were deductible or not, and only you can determine that based on income, retirement plan status, et cetera. Your financial advisor and your CPA can play a role in that.
Step two, be proactive with your CPA. Don't assume they'll catch everything in the forms or know to ask the question. If they don't have context, they're not going to ask the question. So, make sure you say something like, “I made a non-deductible traditional IRA contribution of X amount and converted it to a Roth IRA. Will you please record that so that at the end of the year form 8606 can get filed?” We have clients that do that when we close the communication loop to say, “Hey, your contribution is done, your conversion is done, this is all done.” And they say, “Great, notifying my CPA right now.”
Three, double check your return. If you're doing a strategy like this, know that there is this form 8606 that needs to be in there and you want to make sure it's there and you want to make sure that you're not seeing taxes is owed, or if it is, that it's pennies. And optional, work with an advisor that helps with these strategies and keeps the communication going.
Jon Gay (14:05):
Again, communication, communication, communication. If someone realizes after the fact that they didn't file that form 8606, what can they do?
Amy Walls (14:14):
Okay, first of all, don't panic (laughs).
Jon Gay (14:17):
I like that, okay.
Amy Walls (14:18):
It's easy to fix. Second, you can file form 8606 late. If it wasn't filed, it can be filed as a standalone document. If it was filed and is incorrect or your taxes ended up incorrect, meaning a conversion was fully taxable, you'll need to amend your return and file the 8606.
Know that it's a little bit of a hassle, but I think the key here is pay attention to the process because it is easily avoidable once you understand what role you need to play in that communication.
Jon Gay (14:52):
Well, it goes back to the point you made a moment ago, Amy, which is the IRS is not incentivized to lose potential revenue. So, they don't mind that this is complicated stuff to deal with, but it's a little bit of pain now to avoid a massive financial headache later.
Alright, any final thoughts for somebody using or even thinking about using the backdoor Roth strategy?
Amy Walls (15:13):
First, the strategy itself is sound. The backdoor Roth strategy is not a problem, it's just vulnerable to reporting errors. You might want to think of it like a recipe. If you leave a key step out, maybe the last ingredient to add is flour. And you get busy, and you forget to add the flour, the whole recipe doesn't work and flops; the same thing can happen.
Know that the IRS is not out to get you on this; they're not trying to punish anyone, but they can only go by what's filed. And like I said, the custodians don't know what you're going to do on your tax return, so they can't say. So, the IRS is going to make essentially those same assumptions your CPA made. So, it's going to be up to you to find this.
And if you're doing the backdoor Roth strategy, go into it knowing you're going to need to own the reporting piece. It's not somebody else. It is, I'm taking this on as my strategy, there is a tax reporting piece of this that I now have to own.
Jon Gay (16:27):
That makes sense. Amy, again, this stuff is technical and again, communication is key with both a CPA and in many cases, a financial professional. If somebody wants to come talk to you and your team at Thimbleberry Financial, how do they best find you?
Amy Walls (16:38):
They can reach us online at thimbleberryfinancial.com or give us a call at 503-610-6510.
[Music Playing]
Jon Gay (16:46):
Really important stuff, we don't want people to make that expensive mistake, Amy. Thanks again, we'll talk soon.
Amy Walls (16:51):
Sounds great, Jag. Looking forward to it.
Voiceover (16:53):
Securities offered through registered representatives of Cambridge Investment Research Inc, a broker dealer, member of FINRA/SIPC. Advisory services through Cambridge Investment Research Advisors, Inc., a registered investment advisor. Cambridge and Thimbleberry Financial are not affiliated.
Discussions in this show should not be construed as specific recommendations or investment advice. Always consult with your investment professional before making important investment decisions. Securities offered through registered representatives of Cambridge Investment Research Inc, a broker dealer, member FINRA/SIPC. Advisory services through Cambridge Investment Research Advisors, Inc., a registered investment advisor. Cambridge and Thimbleberry Financial are not affiliated.