Backdoor Roth for Business Owners: The Pro-Rata Trap
How high earners fund a Roth IRA through a conversion, why a SEP or rollover IRA breaks the math, and the larger version inside a Solo 401(k).
Reviewed by the Fairlight Accounting cross-border tax team — U.S. & Canadian Tax Desks
A backdoor Roth is a nondeductible traditional IRA contribution followed by a conversion to a Roth IRA, used by people whose income is above the Roth contribution limits. It is clean only when you hold no other pre-tax IRA money; otherwise the pro-rata rule taxes part of it. Owners with SEP or rollover IRAs are the ones most often caught.
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How does the basic version work?
- Contribute to a traditional IRA (up to the annual IRA limit) and do not deduct it.
- Convert the balance to a Roth IRA, ideally before it earns much.
- Report the nondeductible contribution and the conversion on Form 8606.
Because the contribution was after-tax, a prompt conversion produces little or no tax. The money then grows tax-free and has no required distributions.
What is the pro-rata rule?
The IRS treats all your traditional, SEP, and SIMPLE IRAs as one account on December 31 of the conversion year. The tax-free portion of a conversion equals your after-tax basis divided by the total balance.
| Situation | Result of converting a $7,500 nondeductible contribution |
|---|---|
| No other IRA balances | Nearly 100% tax-free |
| $92,500 in a SEP IRA from prior years | Only 7.5% tax-free; 92.5% of the conversion is taxable |
You cannot choose to convert "just the after-tax part."
How do business owners fix it?
Roll the pre-tax IRA balances into a 401(k) — including a Solo 401(k) — before December 31. Employer plans are outside the pro-rata calculation. Once the IRAs hold only the new nondeductible contribution, the conversion is clean. Owners who use a SEP each year should consider a Solo 401(k) instead, which receives the same employer contribution without creating IRA balances.
What is the mega backdoor Roth?
A 401(k) that allows after-tax (non-Roth) contributions and either in-plan Roth conversions or in-service withdrawals lets a participant fill the overall annual limit — $72,000 for 2026, counting deferrals and employer contributions, plus any catch-up deferrals ($8,000 at 50 or older, $11,250 at ages 60 to 63) — and convert the after-tax portion to Roth. In a Solo 401(k) there are no other employees to test against, so an owner can use the full room. The plan document must specifically permit after-tax contributions.
What are the limits for 2026?
For 2026, the traditional and Roth IRA contribution limit is $7,500, plus a $1,100 catch-up at age 50 and over ($8,600 total), up from $7,000 and $1,000 for 2025. Roth contributions phase out at modified AGI of $153,000 to $168,000 for single filers and $242,000 to $252,000 for married couples filing jointly. Conversions have no income limit.
Frequently asked questions
Is there a waiting period between contribution and conversion?
No statutory waiting period. Many people convert within days to limit earnings.
Does the conversion count toward the five-year rules?
Each conversion has its own five-year clock for penalty-free withdrawal of the converted amount before 59½, separate from the five-year rule for earnings.
Can my spouse do one too?
Yes, with their own IRA and their own pro-rata calculation.
Can I undo a conversion?
No. Recharacterizing a conversion has not been allowed since 2018.
Official sources
The IRS explains: “Use Form 8606 to report: Nondeductible contributions you made to traditional IRAs.” — Internal Revenue Service, About Form 8606, Nondeductible IRAs, https://www.irs.gov/forms-pubs/about-form-8606
The IRS explains: “Beginning in 2026, the IRA contribution limit is increased to $7,500 ($8,600 for individuals age 50 or older) from $7,000 ($8,000 for individuals age 50 or older).” — Internal Revenue Service, Publication 590-A (2025), Contributions to Individual Retirement Arrangements (IRAs), https://www.irs.gov/publications/p590a
Next step
Fairlight Accounting handles U.S. domestic, cross-border (U.S.–Canada), and international tax returns, plus bookkeeping, payroll, and CFO advisory. Our U.S. Tax Desk checks IRA balances before any conversion and prepares Form 8606. See pricing or book a free fit call.
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