IRA Conversion Loophole?
Hi,
I have an idea to avoid paying taxes on my gains on my IRA conversion and I want to know if it is legal. I have contributed $9000 (2007 and 2008) to a traditional IRA without taking the deduction. Since then I have been very lucky and increased it’s value to over $14,000 (despite the down market). I was planning to convert it to a Roth in 2010, forcing me to pay taxes on $5,000. But then I thought of this (possibly clever) plan. I have never bought a house so I can withdraw $10,000 from the IRA for the down payment. Once I do that, I think my cost basis is still $9,000, which means effectively I’m in the negative by about $5,000 ($14,000-$10,000-$9,000), thus owning no taxes. In fact, if this works, I might wait as long as I can to buy that house until my cost basis is around zero to avoid paying taxes on $10,000 of gains. Does this work?
I have one more related question. I have forgotten to file the 2007 and 2008 8606 forms to keep track of my nondeductible contribution. When I called the IRS, they say I can still file, but need to pay a $100 penalty. In a recent article in the WSJ, Ed Slott was quoted in a way as to imply there is another form to file to avoid this $100 fee. Is this true?
Thanks for reading my questions!
Permalink Submitted by Alan Spross on Wed, 2009-06-24 03:22
The good news here is that the IRS has been accepting the retroactive 8606 forms without levying the penalty. The person you talked to was just reading from p 18 of Pub 590, but the IRS has not been billing the penalty for years, even though they could. You should download the 07 and 08 editions of the Form, complete them and send them in. If you have a real good excuse for not filing them with the returns for those years, include that on the bottom of the forms. There is no other special form needed.
Despite some creative thinking, your other plan will not work the way you planned. Any traditional IRA distribution (or conversion) is pro rated between your basis and the total value. So if you withdrew 10,000 on a qualified first home purchase, the taxable amount would be 5/14 of the distribution or $3,571. The other $6429 would be your tax free basis and it would reduce your remaining basis to $2571. This is also calculated on Form 8606, Part I. There is no penalty on the taxable portion since the first home purchase is an exception to the penalty. If you have any other traditional IRA accounts, they have to be added into the calculation as well, since all traditional, SEP or SIMPLE IRA accounts are combined into a single total for tax purposes. If you then converted to a Roth IRA, the conversion would also be taxed on a pro rated basis, ie a 4,000 conversion would generate tax on $1429, and the remaining $2571 would be tax free. If you were in the 15% bracket, your total tax for both these transactions would be 15% of 5,000 or $750. Of course, you need to file the retroactive 8606 forms prior to this.
Now let’s see what happens if you convert first and this is your first Roth IRA. The conversion of 14,000 would generate a tax on the 5,000 pre tax amount or $750. You would then take 10,000 from your Roth IRA for the first home purchase, but that 10,000 has already been taxed. The conversion 5 year holding requirement for the early withdrawal penalty is waived due to the first home purchase, so the Roth distribution is tax free.
Net result is the same either way as you can see.