Can take capital loss on “underwater” conversion to Roth?

Submitted by Matthew Soscia on Wed, 2009-06-24 17:51

hi. i haven’t seen this specific issue addressed on this board, although i found some related posts where i can deduce the answer. i’d rather ask anyway, though, to be sure.

so i currently have a Traditional IRA that is worth $11,500. over the years i’ve put in $12,000 in non-deductible contributions. i’m under the income limits to do the conversion to a Roth IRA in 2009. since my balance is less than my basis, i shouldn’t be taxed anything. my question is since i’m still $500 “underwater”, can i claim that as a capital loss against my other capital gains and income outside this account?

i found a couple other threads that say a Roth conversion is considered ordinary income. that would make it seem like i would only pay tax on any difference over $12,000. but if it’s less, i can’t take a capital loss? that’s weird, though, if so, since i had all mutual funds in the Traditional IRA to begin with, and so the loss is essentially a capital loss.



Submitted by Anonymous (not verified) on Wed, 2009-06-24 18:08

Unfortunately, you cannot take a loss on IRAs, except in one situation.
Think about it this way. When you have gains in an IRA, you would never expect the IRS to tax you on an annual basis. This may be “weird”, but I have never seen a taxpayer allowed to take a loss, except…..

[u]The one situation[/u] – You distribute ALL your IRAs (by type – either Trad or Roth) and you are allowed to take a loss on the unrecovered basis, ie. your $500).
Source: Pub 590, p. 41
http://www.irs.gov/pub/irs-pdf/p590.pdf

pmk



Submitted by Joseph Arsenault on Wed, 2009-06-24 21:42

To add one more point, even if you do qualify for a loss, in the fashion that pmk explained, it is not considered a capital loss.
You can take the loss as a miscellaneous itemized deduction, subject to the applicable 2 percent-of-adjusted-gross-income limit.

-j



Submitted by Anonymous (not verified) on Wed, 2009-06-24 21:45

Yes. Good point monsta.

pmk



Submitted by Alan Spross on Wed, 2009-06-24 22:24

I agree with the above, but this opens up another question that the IRS has never clarified. If you convert this account and it is your only TIRA, you can take the itemized deduction if you closed all your IRAs of the same type. The IRS has never said how long these accounts must be closed, but I would avoid making another current year TIRA contribution, whether deductible or not, in the same year you did the TIRA closing Roth conversion. If you make a 2009 regular TIRA contribution, the custodian issued 5498 would tell the IRS that you indeed have a TIRA balance at year end 2009. It would look like you never closed your TIRA completely. You would probably be safe making new contributions for the following year, but again, the IRS has not ruled how long the TIRA (or Roth which is more often closed for the deduction) needs to remain closed.



Submitted by Anonymous (not verified) on Wed, 2009-06-24 22:39

That makes the IRA world so interesting. Sometimes so much vagueness, sometimes so many unaddressed issues…..

“Voluntary compliance” and you better have a good defense when they audit you for a minor, unrelated issue. Because, even some of the PLRs will throw some strange logic at you when you challenge them….. 😀

pmk



Submitted by Matthew Soscia on Thu, 2009-06-25 04:55

thanks, guys. i just read the section “Recognizing Losses on Traditional IRA Investments” on p.41, and looks like i CAN take the “capital loss” then, but just described as something else. glad i asked. and no, i wouldn’t contribute any more to my Traditional IRA anyway, as i can put directly into Roth now. and it was my only Trad IRA until a couple months ago, when i made a boo-boo. This just makes things more complicated now. So I rolled over my 401k into another Traditional IRA, and that was all pre-tax stuff, and a significantly larger amount. I may be able to reverse that whole thing for a minor fee… I’m still looking into that option at the moment. Otherwise it would be silly to convert just the smaller $12K one to Roth, as i would then have to pay a hefty pro-rata tax on it after all. So then my other choice is to convert both at once, but then i’d be paying a lot of tax i’d rather not be paying right now if i can avoid it. but just for the sake of argument, if i weren’t to reverse it, could i calculate my “unrecovered basis” or “capital loss” for my bigger Trad IRA, too?… it’s just a lump-sum at the moment, although i could very well have a loss in there over time, too, if i went back and checked the details back when it was a 401k. or is it rather that when you do a 401K -> Trad IRA conversion it is always considered ordinary income no matter what in that case? wait, i bet it is, as i just realized that any capital loss would already be built-in to the Trad IRA since i hadn’t paid taxes on *any* of it yet. is that right?



Submitted by Joseph Arsenault on Thu, 2009-06-25 14:35

ms9

You could certainly try to move your pre-tax funds back into an employer plan like a 401k to isolate the basis for a conversion if permitting.

Remember. there are no “capital losses” with fully liquidating your IRAs by type and ending up with some unrecovered basis. See my above post. The 2% misc itemized loss category is much different. There is a 2% floor (of your AGI) you must surpass to start getting the benefit of the deduction, and there is no carry forward like with capital losses.

Also, pertaining to your last statement, if you have no basis in your larger TIRA, there is no loss built in.. The only way you can recognize a loss is to fully distribute all your like kind IRAs and have “unrecovered basis” Based on what you are saying, you don’t have basis to be “unrecovered”. You actually started by saying its all pre-tax money and then ended by asking if you could calculate the unrecovered basis. Basis comes from after tax contributions. So if you didnt pay taxes on any of the contributions to your 401k, there will be no basis and no loss recognized.

You could figure out the pro rata amount of basis in your TIRAs and then just calculate how much total you can afford to convert each year until you have reached your goal.



Submitted by Matthew Soscia on Fri, 2009-06-26 05:14

so i got confused by one line, and i probably confused others with another.

so when i read the line “subject to the applicable 2 percent-of-adjusted-gross-income limit”, i originally thought i could only claim a loss up to 2% of agi. but now i realize it’s that i can only claim whatever comes out to be MORE than 2% of agi. that probably won’t amount to much of anything on a $500 loss, so i can’t really claim the full thing after all.

and when i said “unrecovered basis” or “capital loss” for my bigger Trad IRA, i meant in the sense of the actual mutual funds, say, purchased in there, so rather the basis for those investments. like say i had contributed $50,000 to my 401k over time, but investments had brought it down to $45,000. the capital loss there would normally be $5,000. but as i then further realized and said, it was really more “built-in”, as it’s coming from a 401k. so it’s like having to pay tax on $50,000 then taking a “capital loss” of $5,000 is really SAME THING as taking ordinary income of $45,000. so we end up in same place no matter what, except for details of not having a carryover on the loss or what have you. so essentially i think we were saying the same thing here.

ok, so i think i’ve learned how all this works, now i just need to figure out a strategy for how to proceed here, based on my individual circumstances, and which still have many unknowns for 2009 as well. i guess i will revisit this and make my move around Nov/Dec timeframe then.



Submitted by Clyde Wolf on Sat, 2009-06-27 01:17

And to take the loss as a Miscellaneous Deductong subject to 2% of your AGI, YOU also need to ITEMIZE your Deductions.



Submitted by Tom Davison on Sun, 2009-07-19 21:54

Also note that if you were to do a deductible IRA contribution up to the amount you are underwater, you could include those dollars tax-free in the roth conversion, and get a deduction. Call it effectively a deductible Roth contribution.



Submitted by fairira on Sat, 2009-07-25 18:26

I would think that putting in a $5,000. deductible IRA contribution means your IRA now has both $5,000. in deductible (pre-tax) and $15,000. nondeductible (post-tax) contributions. Then, if you do a Roth IRA conversion, the $5,000. will be taxed as a “distribution” and the $15,000. will convert tax-free.



Submitted by Tom Davison on Sat, 2009-07-25 20:20

Say you have $15,000 of basis, but the IRA value is $10,000. You add $5,000 of a deductible contribution, and then do the conversion. You report the total value, which would then be $15,000, and the basis,which is also $15,000. Note that you don’t report the total deductible contributions, just the balance and the non-deductible basis. There is nothing to tax. Form 8606 is the place to report this, and the instructions lead you thru the calculations.



Submitted by Alan Spross on Sat, 2009-07-25 22:22

I agree that this approach is preferable since an above the line IRA deduction generally reduces taxes more than an equal amount of misc itemized deductions. Even if you did not have to worry about the 2% AGI floor for the misc deduction, having the IRA deduction will reduce AGI and therefore increase the amount of medical deductions if they exist and eliminate the possibility of losing the misc deduction due to AMT.

However, in order to execute this strategy, you must have a TIRA that is valued less than basis and that means having made non deductible contributions or after tax rollovers over the years. This generally does not happen except for those whose MAGI is too high to deduct the TIRA contribution for a few years. That same person would then have to have low enough MAGI or job loss in the year of the current contribution to be able to deduct the current year’s contribution. Putting all of these conditions together is rather unlikely, but if they happened to materialize, the IRA deduction would be preferable to the misc itemized deduction for closing the TIRA due to total conversion less than the basis.



Submitted by Matthew Soscia on Tue, 2009-12-29 06:31

i’m revisiting this issue at end of this year as i mentioned above. yes, this is a good idea here, tcdavison, the “deductible Roth contribution”. and yes, alan-oniras, i pretty much DO fit that unlikely situation you’ve described, but with the only difference that it’s even to the extent that i have NO earned income for 2009 to make such a contribution! the other thread where i just asked about this subpoint is at [url]http://www.irahelp.com/forum/viewtopic.php?f=1&t=4388%5B/url%5D.

i already did the 2 full conversions anyway, too, i.e. both the “big” 401k -> Roth, and the ” Roth. so seems i have no choice but to take the “2% AGI floor for the misc deduction” route at this point. and i now know that i can add other misc deductions to that as well to get the *total* to be over 2%. so that’s a little better.

i guess the “good news” overall here, though, is that i won’t have to pay much taxes on my 401k conversion as i expect to be in a low tax bracket this year. so a good year to do it then, and all at once as well.



Submitted by Matthew Soscia on Wed, 2009-12-30 03:47

i think i just came to an “aha” revelation today. it seems i can’t do the favorable “deductibe roth” idea, but there is something else better than the 2% thing that i totally overlooked. i can still essentially deduct the full amount in a fairly straightforward, simple manner anyway. since i’m doing both conversions in one year and it’s pro-rata, my non-deductible basis of $12k will still hold such that any loss there will then automatically swap to the other 401k conversion side and be taken care of over there.

someone please correct me if i’m wrong!

now looking back up this thread, i think that monsta_24 was alluding to this already: “The only way you can recognize a loss is to fully distribute all your like kind IRAs and have “unrecovered basis””.



Submitted by Alan Spross on Wed, 2009-12-30 04:33

ms9,

I am not sure I understand your complete situation here, but it sounds like you did one conversion directly from a 401k and the other from a TIRA account. You might have basis in one or other of those accounts, but the basis is not combined in two different types of retirement accounts. However, you would still qualify for a misc itemized deduction for the excess of basis in the IRA over the amount of the closing distribution of all your IRAs.

If you had after tax contributions in the 401k that exceeded the value of that account upon direct conversion to a Roth IRA, that “loss” is not eligible for the misc itemized deduction. I think it can be taken on perhaps on line 21, but would have to look that up if this is the case.

Can you confirm if you did a direct conversion from a 401k and if your basis in that account was more than the value at conversion — or is the 12k of basis totally in your traditional IRA?



Submitted by Matthew Soscia on Wed, 2009-12-30 07:48

alan, i did 2 conversions this year. 401k -> Rollover (Trad) IRA -> Roth IRA and my other TIRA -> Roth. I have no other IRAs. the 401k is all pre-tax. the other TIRA is $12k previously-taxed (all from non-deductible contributions) and has the lost basis (which ended up being only $250 now, btw). i thought the pro-rata rule dictated i had to combine these 2 accounts for calculating the overall portion not to be taxed, i.e. 12k / (x + 12k), where x is value of converted 401k rollover.

so the 401k conversion was not direct to Roth, but via a Rollover/TIRA. The basis in such an account would be irrelevant, right? So yes, the 12k of basis was totally in the other TIRA.



Submitted by Matthew Soscia on Sun, 2010-01-17 07:16

bump. hi alan, can you confirm? thx, ms9



Submitted by Alan Spross on Sun, 2010-01-17 16:59

OK, since both conversions were from TIRA accounts, you are correct that the pro rate rules do apply to both 2009 conversions. The tax free portion of each conversion will be the same since they both use the same year end adjusted value to determine the pro rate factor.

Also, in your first post you mentioned about a “swap” of basis, and that is what happens when your first IRA value drops below the 12,000 amount you contributed. The excess amount of basis is applied to all your TIRA accounts and is therefore applied to the 401k rollover IRA as well. So you will not have to get into misc itemized deductions here.

I think you converted your entire TIRA balance. and the way this works out, 12,000 of that amount will be tax free and the balance will be included in income. Also, note that if you make an IRA contribution FOR 2009 between 1/1/2010 and 4/15/2010, it will not be counted in either your year end 2009 balance AND it will not increase your 12,000 basis for purposes of determining the tax free amount for your 2009 conversions. If you complete Fomr 8606 correctly, it will take care of all the proper calculations.

The only other issue here is that you need to be sure that you filed an 8606 for each year in the past that you made any of the non deductible contributions that eventually totalled to 12,000.



Submitted by Matthew Soscia on Wed, 2010-01-20 21:15

ok, alan, thanks for the confirmation. it looks like my plan will work for 2009 then. also i won’t be making any 2009 contributions anyway, as i had no earned income for 2009 (or can you use 2010 earnings to apply to 2009 contributions before Apr deadline??). and i believe i did fill out all the 8606s necessary for each of those contributions. i keep pretty good records and have all my old tax returns saved. ok then. regards, ms9



Submitted by Alan Spross on Wed, 2010-01-20 22:11

Right. You cannot make a regular IRA contribution if there is no earned income in the year the contribution is assigned to.



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