Learn From My Mistake — Kenny Kim’s Backdoor Roth Conversion Failure

How a SEP IRA and the Pro Rata Rule screwed me over

May 26, 2025

The best way to learn is from someone else’s mistakes.

So, learn from mine - Kenny Kim’s.

When I started making real estate income in 2020, I knew it was time to shelter some of it in a retirement account. Without thinking too hard about it, I opened a SEP IRA.

Why?

Because I read that a SEP IRA is free to open and easier to manage than a Solo 401(k). It sounded like a smart move—until it wasn’t.

What I didn’t realize was that the pro rata rule, triggered by my SEP IRA, was about to screw up my backdoor Roth conversion.

The Mistake: A SEP IRA That Burned My Backdoor Roth

I contributed $7,000 to my SEP IRA without realizing the consequences it would have on my backdoor ROTH IRA conversion. I had already put $7,000 of after-tax money into a Traditional IRA, planning to convert it to Roth.

What I didn’t know was that SEP and Traditional IRA are treated as one big pot of money for conversion purposes.

And that’s where I got burned.

Tax Trap #1: IRA Aggregation Rule

Even though SEP IRAs and Traditional IRAs have different names, they’re treated as one big part of the same family when it comes to conversions - like the backdoor Roth. This is known as the IRA Aggregation Rule.

So when I contributed $7,000 of pre-tax money to my SEP IRA and $7,000 of after-tax money to my Traditional IRA, the IRA saw just one $14,000 pot. I couldn’t “choose” to convert only the after-tax portion—because it was considered mixed together with the pre-tax portion.

Tax Trap #2: The Pro Rata Rule

So what happens when I try to convert $7,000 from the $14000 IRA pot to a Roth?

The pro rata rule screwed me over!

This rule says that any amount I convert to a Roth must come proportionally from both pre-tax and after-tax dollars in my IRA balance. I don’t get to pick and choose.

Back to my example:

$7,000 SEP IRA (pre-tax)
$7,000 Traditional IRA (after-tax)
Total IRA balance: $14,000

When I tried to convert $7,000 to Roth, the IRS treated it as it like this:

$3,500 from the SEP (pre-tax) => taxable
$3,500 from the Traditional IRA (after-tax) => non-taxable

That meant I had to pay tax on the $3,500 pre-tax portion.

And the remaining $3,500 of after-tax money?

Still stuck in my Traditional IRA - growing tax-deferred but not tax-free like a Roth. I’d still owe tax on the growth when I pull it out in retirement.

If I had tried to “clean things up” by converting the full $14,000, I would’ve owe tax on the entire $7,000 pre-tax SEP balance - basically wiping out the deduction I got when I contributed to the SEP in the first place.

Ouch.

The Pro Rata Rule: The “cream in the coffee” rule.

The “cream in the coffee” rule is a nickname for the pro rata rule.

Imagine your IRA is a cup.

You first pour in black coffee - that’s your pre-tax money.

Then you add some cream - that’s your after-tax money.

You give it a swirl to mix them together.

Once mixed, you can’t scoop out just the cream - each sip now contains both cream and coffee.

The swirling? That’s the IRA Aggregation Rule - treating all your IRAs as one blended account.
And the sipping? That’s the Pro Rata Rule - every Roth conversion (every “sip) includes a proportional mix of both pre-tax and after-tax dollars.

You don’t get to pick and choose.

Solution #1: Solo 401(k) – Say No to a SEP IRA

Here’s what I wish I had done: open a Solo 401(k) instead of a SEP IRA.

Why?

Because a Solo 401(k) is not an IRA. It lives in a different part of the tax code (§401, not §408). That means it’s not subject to the IRA aggregation rule.

As a result, your pre-tax Solo 401(k) balance is invisible to the pro rata rule when you do a Roth conversion from your Traditional IRA.

Even better? Solo 401(k) plans are free to open at Fidelity and many other custodians, just like SEP IRAs.

Sure, you have to file Form 5500-EZ annually if your account balance exceeds $250,000 - but honestly, that’s a good problem to have. And likely many years away if you’re just getting started with a side gig.

Solution #2: Reverse Rollover – Cleaning Up the Mess (“Cream”)

If you’ve already opened a SEP IRA and made pre-tax contributions like I did, there’s still a way out: the reverse rollover.

Here’s what it might look like to undo my screw-up:

Open a Solo 401(k)
Roll over the $7,000 pre-tax SEP IRA funds into the Solo 401(k)
Now the SEP IRA is empty.

With no pre-tax funds left in the “big pot” of IRA, the pro rata rule no longer applies.

That means, the $7000 backdoor Roth conversion will come entirely from the $7000 of after-tax money in the Traditional IRA - and the conversion will be completely tax-free!

One caution: Make sure your Solo 401(k) provider allows inbound rollovers. (Fidelity does.)

Solution #3: Roth SEP IRA – Thanks to SECURE 2.0

Here’s a new option, thanks to SECURE 2.0 Act, the 2022 tax law that took effective in 2023: you can now open a Roth SEP IRA.

Had I done this, my SEP contribution would’ve been made with after-tax dollars. That means both my Traditional IRA and SEP IRA would’ve contained only after-tax money—all cream, no coffee.

In that case, converting to Roth would not trigger any tax under the pro rata rule.

But here’s the downside: I would’ve lost the current-year tax deduction for contributing to the SEP IRA. And with my high marginal tax rate, that’s a trade-off I wasn’t willing to make.

So in my case, the Roth SEP IRA wouldn’t have been the right fit.

One more thing: As of now, many custodians still don’t offer this ROTH SEP IRA options yet - so even if this sounds appealing, the logistics might not be there yet.

The Bottom Line

If you’re doing a backdoor Roth IRA, opening a SEP IRA can be a trap.

Because of the IRA aggregation rule and pro rata rule, a SEP IRA can make your Roth conversion largely taxable, which would undo the benefit of your SEP deduction in the first place.

Instead, consider a Solo 401(k):