CP2000 for a Backdoor Roth Conversion

If you’ve received a CP2000 notice for a backdoor Roth conversion, there’s a good chance you haven’t done anything wrong. The IRS sometimes has trouble tracking these transactions, so you’ll just need to provide an explanation to the IRS to get things sorted out.

What’s a Backdoor Roth Conversion?

A backdoor Roth conversion moves money from a traditional IRA or 401(k) into a Roth IRA. The purpose is to get the post-tax benefits of a Roth account. It’s called backdoor because people using these conversions often aren’t eligible to contribute directly to an IRA.

Debate over whether backdoor Roth conversions were illegal step transactions was ended by the Tax Cuts and Jobs Act recognizing them as a legitimate tax move.

Why Did You Get a CP2000 Notice for a Backdoor Roth Conversion?

In most cases, the paperwork got crossed up. You need to file a Form 8606 when you file your tax return, the broker you took the money out of must issue a 1099-R, and the receiving broker may need to report the transfer in. It is very common for one party to check the wrong box or for the IRS computers to not properly match things up.

Converting Pre-Tax Contributions

If you’re converting a pre-tax contribution, it should cancel out. For example, if you contributed $5,500 to a traditional IRA, you will receive a $5,500 deduction. If you immediately convert that money to a Roth IRA with no gains or losses, you’ll report $5,500 in income.

You might receive a CP2000 notice if the IRS was notified of the conversion but not the contribution.

Converting Post-Tax Contributions

A backdoor Roth conversion typically converts post-tax contributions. A common scenario is that your income is too high for both tax-deductible traditional IRA contributions and for Roth IRA contributions. In this scenario, you can still contribute to a traditional IRA but you receive no deduction.

If you leave the money in the traditional IRA, you will have to pay taxes on the gains when you withdraw them in retirement. If you immediately convert to a Roth IRA, you won’t have to pay taxes on the gains in the future.

Because you didn’t receive a deduction for your post-tax contributions, you don’t pay tax when you convert them. However, the IRS often doesn’t realize that contributions were post-tax and issues a CP2000 notice anyway.

You May Owe Tax if You Made Both Pre-Tax and Post-Tax Contributions

A common error by tax payers is to do a backdoor Roth conversion with post-tax contributions after they’ve already made pre-tax contributions. This is allowed, but the math is more complicated.

Take an example of $5,500 in pre-tax in 2021 and $5,500 in post-tax contributions in 2022 made into IRA accounts at two different brokers. If you do a backdoor Roth from the 2022 account, you are not just moving post-tax funds.

All of your traditional IRAs are considered one big pot regardless of where you keep them and what year the money is from.

The proper tax reporting for the above example is a $2,250 taxable conversion of pre-tax funds and a $2,250 nontaxable conversion of post-tax funds. (Note that to calculate the exact amount you’d have to factor in potential gains or losses on your contributions rather than just the contribution amounts).

In this case, you would receive a CP2000 notice from the IRS and would owe tax.

What’s the Right Way to Handle Your 1099-R?

When you do a backdoor Roth, you’ll get a 1099-R from your traditional IRA provider. They’re required to report that you took money out of your traditional IRA. You’re not required to pay taxes on money that’s not actually taxable.

When you fill out Form 8606 when you file your tax return, you can mark your traditional IRA contribution as not deductible. If your contribution wasn’t deductible, you don’t pay taxes on it when you do the backdoor Roth conversion. The IRS should match up your Form 8606 with your Form 1099-R. Again, this is supposed to stop you from getting a CP2000 notice, but things don’t always work as expected.

Note: If you don’t do your conversion immediately, you might owe tax on a small amount of earnings. For example, if you deposited money into a traditional IRA, earned $10 in interest from your settlement account, and then did the conversion, you’ll have to pay income taxes on that $10.

If you’re not sure what to do, you can chat with a tax expert online.

How to Respond to a CP2000 Notice for a Backdoor Roth Conversion

To respond to your notice, you’ll need the following information:

• Your original tax form.
• The tax forms issued by your brokers.
• Your retirement account statements showing the conversion, contributions, and account values on the contribution and conversion dates.

Write a letter to the IRS explaining what you did and why the CP2000 is incorrect. Attach copies (not originals) of your supporting documentation to your letter.

If you aren’t sure if you did things correctly or that you can clearly explain to the IRS why they’re wrong, bring your information to a tax professional.