TIRA IRA Basis After Conversion
Client converted entire TIRA to Roth funded entirely with nondeductible contributions, and there are no other TIRA’s. The converted amount was valued at less than basis so there is basis remaining. My understanding is that since all of the IRA was distributed by converting, that a loss can be taken as a miscellaneous deduction. In a phone conversation with an IRS agent quoting from Pub. 590, the agent stated that all TIRA accounts must be “distributed”, meaning not converted but actually distributed to you. Is this correct?
If a loss deduction can be, but is not used, is this basis lost. What if an additional nondeductible contribution was made, could the remaining basis be added to the new contribution.
A stand alone Form 8606 is also needed to report a nondeductible contribution for a prior year. I was advised to mail this to the IRS service center for current (2011) returns, and not to the center where the original return was processed.
Ed C.
Permalink Submitted by Alan Spross on Fri, 2012-03-30 19:16
Ed,
No, the IRS statement is not correct. A conversion is a distribution and a rollover to a Roth, so the conversion IS a distribution.
Your second question does not have a certain answer since the IRS has not issued guidance on this. Of course, if the misc deduction is claimed that would eliminate all existing basis as it would be used for the deduction. If the misc deduction is not used, there is a question if basis survives when there is no balance in a TIRA, SEP or SIMPLE IRA, particularly at year end for 5498 purposes. The solution to this is NOT to totally close all of these IRA types unless the deduction can be applied. Keeping a balance will certainly preserve the basis. If a full conversion has been done, a new IRA contribution (deducted OR not deducted) in the same year should preserve the remaining basis for future use and there will be a year end value. If taxpayer is not eligible for a contribution (eg retired), then a small partial recharacterization of the conversion will restore some basis, preserve unused basis, and provide the TIRA year end account balance.
The only issue in leaving a very small balance in the TIRA is that it might result in small account fees.
A related question is how soon could you make a new contribution after using the misc deduction? Again, no IRS guidance, but I think you would need to not restore a balance to the IRA type until the following calendar year, ie there should be no 5498 showing a year end balance and raising doubt over the IRA closure.
Permalink Submitted by Edward Czapor on Fri, 2012-03-30 20:58
Alan,
My real concern is the preservation of basis. There is not enough loss for a deduction, and I only questioned the agent on that to see what response would be given. When I asked about the remaining basis, the agent indicated that it would be lost in this situation. When you state that a new IRA contribution in the same year should preserve the remaining basis, do you mean that it must have been made in the same year as the distribution (2011). Or would a contribution made now for 2011 before the due date accomplish this.
Permalink Submitted by Alan Spross on Fri, 2012-03-30 22:59
I would certainly like to know which citation the agent could use to support the contention that the basis would be lost. I know of no reference either way. The 8606 Inst for line 17 indicate that the full basis should be entered, ie the line 2 amount, and this could be more than the converted amount. Yet line 18 does not indicate that you should not enter less than -0- and that line 18 goes to line 15b of Form 1040. But line 15b cannot be negative. This all suggests that the possibility of basis in excess of TIRA balance never occurred to the IRS.
But Part I of Form 8606 clearly preserves basis in excess of that used in a partial conversion on line 14, and this is the reason I suggest to leave some small balance in the TIRA. If you drained the TIRA in a conversion in 2011, and then made a 2011 contribution as late as 4/2012, then you must complete Part I of Form 8606 and that will leave a basis amount for the future on line 14. This helps to make a case for saving unused basis.
But the second part of this is the Form 5498 factor. If the contribution is made after 12/31/2011 it will show on Form 5498 as a 2011 contribution, BUT it will not show in Box 5 of Form 5498 as a 12/31/2011 balance. This means if the IRS looks for -0- balance to confirm that all you IRAs were closed at year end and they consider this a factor as the agent suggests, the 2011 contribution should be made before year end 2011 to avoid showing the IRS that you had -0- value at a particular time.
The third item to be considered is the outstanding rollovers/recharacterizations rules that operate to erase a period of absence from an IRA. Among these rules are that you cannot remove all your TIRA funds before year end and roll them back later to escape the RMD requirements based on year end value. And you cannot recharacterize a conversion if you are otherwise subject to RMDs without increasing the year end value by the amount of the recharacterization transfer. This suggests that even if there is a -0- balance, a recharacterization would restore a balance, and therefore a partial recharacterization of this conversion would enhance the case for not losing any basis since it would trigger a year end balance in an RMD situation and it would also result in a full Part I of Form 8606 since you no longer did a total conversion.
In summary, these actions do provide a better chance of preserving all the basis in the event the IRS uses certain criteria to look at in making their decision. However, there is plenty of anecdotal evidence that the IRS scrutiny of the 8606 is very much hit and miss, but not but better than taxpayer’s accuracy when it comes to correctly filing or using the form.
Permalink Submitted by Edward Czapor on Sun, 2012-04-01 19:50
Alan,
I don’t think it is possible to end up with a negative amount on line 18. I will attempt to explain how I came to this conclusion, and see if you agree.
You would not complete Part I if all three of the following conditions are met:
1. You made no nondeductible contributions for the current year (line 1).
2. You converted 100% of your TIRA.
3. You took no other non-conversion distributions.
The amount on line 16 is always the amount converted whether entered directly or from line 8. Line 17 is the basis in the amount on line 16 or the nontaxable amount from line 11. Line 17 can therefore never be more than line 16. As for the the 8606 instructions for line 17, line 2 is actually the basis in the converted amount when not completing Part I. This instruction is poorly written and should simply state to use line 2 when not completing Part I. The part stating plus any contributions included on line 1 that you made before the conversion is confusing and should be eliminated since line 1 should have no entry. I believe it is refering to your carryover basis prior to converting.
Permalink Submitted by Alan Spross on Mon, 2012-04-02 01:03
Ed,
The line 17 instructions indicate that if Part I is not completed in the circumstances you listed, the amount you should enter on line 17 is the amount you WOULD HAVE entered on line 2 had you needed to complete Part I. This figure could obviously exceed the amount remaining that was converted. I think the way they worded this line 17 instruction creates the question why line 18 does not indicate the number cannot be negative.
On line 17 of Form 8606 it indicates to “enter your basis IN the amount on line 16”. To me, this does not limit basis to the line 16 amount, but the Inst. for line 17 in the 8606 Inst as noted above takes this intrepretation out of play.
In many of these cases including the taxpayers doing these “back door Roth” conversions, Part I of the 8606 would be needed because they would be making a current year non deductible contribution since their income is too high for a regular Roth contribution or a deductible TIRA contribution. This sets up a different set of issues. They would have an actual line 1 and perhaps 2, but the basis in excess of the total conversion is wiped out by line 10 limiting the decimal to 1.0. That eliminates negative numbers in Part II. Only the non taxable amount (100%) goes on line 17 in this case, but line 14 preserves the excess basis that is more than the non taxable amount of the conversion. All this suggests that closing the TIRA does not eliminate the unapplied basis. Without a Part I however, there is no prior line 14 to support saving the basis.
According to the 8606 Inst, whenever Part I of the Form is next required, the line 2 instruction is to use the figure in the most recent Form 8606 line 14. The result of this is that the unused basis is never expunged when the TIRA balance goes to -0-, but could remain available for an unlimited time for future use unless the taxpayer is able to itemize the loss in the year of closure. So if you go by the 8606 Instructions as indicated, your client would still have the unused basis whenever he would next need Part I or II of the 8606.
If you see anything I may have missed, let me know…………alan
Permalink Submitted by Edward Czapor on Mon, 2012-04-02 15:32
Alan,
I believe the crux of the matter is how you interpret the first phrase in the line 17 instruction, “if you did not complete line 11”. I don’t think this refers to the situation where part I is not completed as I first thought. I think what is meant here is the specific situation when there is no basis carryforward (line 2 is zero) and a contribution is made after the due date. Line 11 would then also be zero or “not completed”. The entire instruction makes more sense in this context. “Any contributions included on line 1 that you made before the conversion” refers to contributions made in the year of conversion and would be included in line 5. In the latter case line 11 would have a value and that amount would go to line 17. The instruction is still redundant since line 11 if completed is zero and line 2 is also zero in the first case, and the entire conversion would be taxable from funds with no basis. In either scenario there can not be a negative figure on line 18.
If Part I is not completed only due to the three conditions the correct amount for line 11 and line 17 is still computed, and I believe the reference to entering the basis that you would have entered on line 2 does not apply. You would enter the basis in the amount converted as instructed on the Form 8606.
Permalink Submitted by Alan Spross on Mon, 2012-04-02 20:57
I am not following the part about line 11 being -0-. Line 11 cannot be -0- if there was any existing basis from prior or current non deductible contributions made by 12/31/11. If line 11 is correctly -0-, then there is no issue about what happens to basis because there wasn’t any to preserve.
I still think there is a problem if only Part II is completed. If Part I must be completed for any of the 3 situations listed there, you will always have a complete Part I because we are stipulating that a conversion was done as well. That includes lines 11 and 14:
1) Line 11 is the amount that goes on line 17, but this amount is limited by the decimal limit of 1.0 per line 10. This decimal limit means that the amount on line 11 cannot exceed the amount converted. The excess basis from lines 1 and 2 end up on line 14, lending support to preservation of unused basis in a full conversion. I think that was the original concern, ie whether any unused or excess basis would survive a complete conversion. Since the next 8606 brings forward the preceding line 14 of the former 8606, this basis still exists (unless you itemize it).
2)We have a different situation if Part I is not needed in the case of a 100% conversion and there are NO 2011 non deductible contributions. In this case there is no Part I and no lines 11 or 14. This is where the 8606 line 17 instruction comes into play and the problem here is that line 17 should be the full basis (no decimal limitation as in Part I). Therefore, in the case of a large prior basis (what would have been on line 2), line 17 could exceed 16 and produce a negative on line 18. This is a problem because we both agree that 18 and more importantly 15b of Form 1040 cannot be negative. That’s the first problem.
The second problem is since there is no line 14, there is a weaker case for unused basis to be preserved for future use. Further, the line 14 on the prior 8606 is no longer valid after the later year conversion. This is the reason that it would be safer to NOT do the full conversion in this situation, but leave a small value in the TIRA. A partial conversion will require Part I to be done, line 11 to go on line 17 and provide a line 14 figure for future use.
Permalink Submitted by Edward Czapor on Wed, 2012-04-04 01:29
Alan,
So far I think we agree on most everything except the confusing line 17 instruction. As I stated earlier , I don’t believe it is applicable to the situation where the three conditions are met for not completing Part I. Note that the line 17 instruction mentions contributions included on line 1. One of the conditions for not completing Part I is that there are no current contributions. Secondly if applied the seemingly inexplicable result of negative taxable income could result on line 18. I believe the line 17 instruction is attempting to address the specific situation when a nondeductible contribution is made (line 1) with a conversion when there is no prior basis. It also comments on the treatment of the line 1 basis when the contribution was made during the year or after year end before the due date. The instruction begins with “if you did not complete line 11”. The only way not to complete line 11 (zero value) is with zero basis on line 2. This would be the case if the contribution was made after year end and no prior year basis. Then if you enter on line 17 the amont from line 2 (which must be zero), you compute the 100% taxable amount on line 18 for the conversion. This is the same result if line 11 was completed with the “amount you would have entered on line 2, zero”. If the contribution was made before year end, line 11 would have a value that transfers to line 17. The only question here is “plus any contributions included in line 1 that you made BEFORE the contribution”. Does this mean if made after the contribution it would be treated as if made after year end, and not included in current year basis?
As you pointed out, if the line 10 factor is more than 1.0 due to excess basis it is limited to 1.0. This in turn limits the amount on line 17 to to the basis in the CONVERTED AMOUNT as on line 11. Therfore where it states to enter basis in the amount on line 16 ( see instructions for line 17) this could be zero or the amount from line 11, and not the basis on line 2 which is already accounted for in lines 10 and 11.
Hope this does’nt keep you awake at night.
Permalink Submitted by Alan Spross on Wed, 2012-04-04 04:05
OK, now I am going to expand this analysis as it is not yet confusing enough 😀
There is another way not to complete line 11. Take a look at Worksheet 1-5 on p 39 of Pub 590. This worksheet is designed to address the inter relationship between MAGI and the permissible TIRA deduction when for example the taxable amount of a conversion also affects MAGI. SInce these two are interrelated, one must be assigned priority. 1-5 appears to artifically increase the basis to the max possible in order to reduce the amount of taxable income as a result of a distribution/conversion and therefore artificially reduce MAGI. The result goes to lines 13 and 17 of Form 8606. There is no line 11 in this case, but there is another decimal limitation in the worksheet to limit the amount going to line 17 of the 8606. Also note the ! point on p 6 of the 8606 Inst.
Incidentally, there are apparently some tax software programs that don’t print lines 6-12 of the 8606 (the indented lines) and that might also relate to this worksheet.
Time to retire for the night, but if you have the time to look at these additional factors, perhaps they explain the line 17 Inst question??