The Tax Return Mistake That Undermines a Backdoor Roth Strategy

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.

To get in touch with Amy and her team at Thimbleberry Financial, call 503-610-6510 or visit thimbleberryfinancial.com.