How I Messed Up Our Vanguard Roth IRA Conversion

Last year I made one of those epic money mistakes that leave you embarrassed and humbled, practically curling up in a fetal ball under a table.

This is the story of how I messed up our Vanguard Roth IRA conversion in 2021. Read on to ensure you don’t make the same mistake I did…

What Is a Roth IRA?

Roth IRAs are a fantastic tool for savings. You put money that’s already been taxed into your account yearly. Then later on, in retirement, you can pull funds out tax-free. Also, your Roth grows tax-free while accumulating money during that stretch of savings.

The Roth flavor of IRA has been around since 1997 and like the original IRA, you can invest in stocks, bonds, or mutual funds (and even annuities). There is a limit to how much you can invest as an individual each year, regardless of what type of IRA:

All this wonderful tax-free wealth building comes with a catch. As your income goes up, the amount you can save with an IRA (Roth or traditional) scales down.

What Is a Backdoor Roth IRA Conversion?

In its simplest terms, the Backdoor Roth is a way for high-income earners to convert traditional IRA dollars into Roth IRA dollars. It’s a loophole for those with incomes higher than the IRS threshold, providing a “backdoor” to qualify for funding a Roth. We happen to be in that category at this stage of our careers.

Why is this a good thing? The Roth IRA grows tax-free and distributions are tax-free. Traditional IRAs also grow unencumbered by taxes, but as with a 401k, you get taxed when you take money out in retirement.

We use Vanguard for our investment accounts. With Vanguard, it was a reasonably straightforward process to convert our traditional IRA account ($42,000 at the time) to a Roth IRA. A click here and a click there on the Vanguard.com website, and you’re good to go.

Now, there are some tax implications. If your traditional IRA was funded by pre-tax dollars (say, from a 401k rollover), the IRS will look to recover the taxes on your next annual filing. You will also need to pay back any 1040 deductions for post-tax IRA contributions converted to the Roth.

So long as your traditional IRA is funded mainly with post-tax dollars, the Roth conversion is a wise money move. I’m not sure it makes sense if you’re sitting on a chunk of pre-tax-funded IRA dollars. This is where you need to sit down and work it out with your accountant.

Thanks to the pro-rata rules applied to Roth conversions, you pay tax only on the traditional IRA dollars that were pre-tax funded. That’s the good news. The bad news is that you can’t choose to convert only post-tax dollars in your IRA. Somehow, the IRS knows what your proportion of traditional IRA dollars is pre-tax and post-tax.

Our Vanguard Roth IRA Conversion Went Sideways

While I thought for sure we were in the clear, it turned out we weren’t. I got a letter from the IRS earlier this summer claiming I owed just north of $8,000 in taxes on our Roth conversion. Sunnuvva…! G#$%%it!… Etc. etc.

Usually, the IRS is right. Usually. Still, I managed to calm down enough to collect some thoughts on this. I figured since the IRA dollars we converted were all post-tax, I shouldn’t be paying anywhere near $8,000. Otherwise, it’s double taxation (19% on top of the 25% or more already taxed).

I wrote an SOS email to our accountant who was vacationing in Mexico at the time. I heard all about his bout of Montezuma’s Revenge three weeks later when he finally returned to Minnesota and got back to me. No hard feelings. Accountants go through a blitz period around tax time and vacations are well-earned come May.

Normally I’m very satisfied with our bean counter. We pay a healthy amount of taxes throughout the year, and he ensures we minimize any additional taxes at filing. Our real estate business and solo-practitioner business typically have major expenses that offset a good chunk of whatever revenues we pull in. A reliable accountant is essential.

How to Recover Money From the IRS

The next step on the Blunder Bus is figuring out how to get our moolah back from the IRS. Is it even possible? Maybe it will be now, with the Inflation Reduction Act, just passed this week: A healthy chunk ($80 Billion!) will be allocated to bolstering the IRS.

Maybe the IRS will become equally good at returning money as they are taking it? We shall see!

Each year the IRS returns billions to Americans who overpaid on their taxes. The figure in 2021 was $14 Billion. This is not chump change!

Our best bet is to keep on our accountant to evaluate our prior year’s returns and gather all of the deductions for the traditional IRA contributions made over the past 10 years. Then, he’ll need to submit an amended return for our 2021 tax filing.

How much can we expect to recover? Even if we can only scrape back a thousand bucks, it’s still a thousand bucks! My gut tells me we overpaid by double at least.

The Moral of the Story

The silver lining in all of this for us is that we’ve managed to achieve a sustainable level of financial independence. We could afford to pay the tax bill from the IRS without an impact on our financial health.

We worked hard to get to this point and have no sour feelings about attempting to make the Roth conversion. The dollars were taxed once before, why let them be taxed again?

Our accountant gave us some new direction last year that makes this whole affair a bit of a moot point. We hadn’t been taking full advantage of the Solo 401k for Mrs. Cubert’s business. With the solid growth in her revenues, we could now focus on funding this tax-advantaged savings account instead of relying on IRAs.

Does the Roth IRA conversation make sense for you? Consider how much of your traditional IRA dollars were funded by pre vs. post-tax dollars as your first step. Then, make sure you have enough disposable income to cover a surprise bill by the IRS.

Finally, before clicking “submit” over at Vanguard or Fidelity, talk to an accountant. If you’ve got a higher household income than most, a conversion may still make sense, but you may want to spread out how much you convert from year to year to mitigate the tax bill.

The Complexity of Personal Finance

My big Roth conversion blunder wasn’t devastating to our financial standing, but it was a stark reminder of how complex personal finance can be. And frankly, it’s more complex than it ought to be.

You’ve got to be some kind of money nerd to figure this $hit out half the time. I thought I was part of this Big Bang Theory cast of armchair wonks, but then THIS happened.

I’ll learn from this and other mistakes that are bound to occur down the road. Still, I wonder if there are opportunities to simplify the system of capital for everyone. Income and wealth disparities continue to grow, and it’s not because the super-wealthy are working harder (or even smarter).

It’s because the system rewards compounding generational wealth.

That in and of itself is not a terrible thing, but if more on the lower rungs of wealth had access to the same tools and resources (accountants, estate planners, etc.) we could shrink down the gap. It’d take 300 posts to spill out all of the thoughts on that philosophy.

But I do have Thomas Piketty’s Capital in the Twenty-first Century on my reading list…

Update: 8/30/22 (Vanguard to the Rescue?)

Since publishing this piece I’ve reached out to Vanguard to research where I went wrong.

Everything the rep shared was what I knew to be true – if you are a high-earning individual or household, the Backdoor Roth IRA Conversion is the tax-preferred route to take.

The catch is you need to submit a form 8606 to the IRS so that the IRS knows the amounts you are converting are post-tax, not pre-tax dollars.

As I mentioned in this post, all of the contributions made to the traditional IRA were with post-tax dollars. Therefore to avoid being double-taxed, IRS form 8606 is CRUCIAL.

Lesson learned. Forehead slapped. Now to get my accountant moving on processing an amended return, with an 8606 signed and delivered. Stay tuned for more money drama…

Update: 9/21/22

I finally heard back from my AWOL accountant. He processed the 8606 forms and submitted amended tax returns to Federal and State. I should be getting my $8K back in a refund, and avoid paying extra to the State. Fingers crossed. More to come…