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You wrote, Your example is what my original question wanted to ask. I forgot to put the words “non-deductible” in front of traditional IRA.

I think aj485 probably understood this was implied.

Also, In your example, let’s say year 2 was a gain of $400. Does the other $600 get carried over to future years?

Let me turn my example around and ask this another way.

Suppose in year #1 I make a $5,000 non-deductible Traditional IRA contribution. I subsequently buy $5,000 of IVV. (iShares S&P 500 ETF) The market goes up and IVV is now worth $6,000. Now I do a Roth IRA conversion, but I only convert $3,000.

The pro-rata rule requires me to make the distribution (conversion) in proportion to the ratio of taxable to cost basis in the IRA. In this case I have $1,000 of taxable earnings and $5,000 in cost basis. So a $3,000 conversion creates a taxable distribution of $500 and a distribution of $2,500 in cost basis.

Notice that the other $2,500 in cost basis has not been wiped out - it rolls into subsequent years.

Now suppose that in year #2 I make a similar $5,000 non-deductible Traditional IRA contribution. Again I invest in IVV and the market goes down instead. Suppose my combined account value falls $1,000 and instead of having $8,000 I now have a $7,000 balance.

Along with this $7,000 balance I now have a $7,500 cost basis. In other words I have a net loss of $500. When I do the Roth IRA conversion, let's say I convert half again - $3,500.

The pro-rata rule requires me to take the taxable and non-taxable portions in proportion. However the taxable portion is now $0. $0 of $7,000 is 0% - so no taxable portion is to be distributed.

The distribution itself is $3,500 and the cost basis was $7,500. This leaves me a new balance of $3,500 and a new cost basis of $4,000. Assuming that at some point in the near future I have $500 in earnings, those will count toward my cost basis - same as if I had not done this conversion.

As far as I can tell, this is how the accounting for Roth conversions works in practice when you don't do a full distribution. At no point do you sacrifice your cost basis here just because at some point during the life of the TIRA your total balance falls below that basis. So I don't see why taking the balance to $0 should sacrifice that basis either.

If I am wrong the smart thing to do would be to convert all but $1 of the balance each time you convert. $1 is so small that it's unlikely to add to your earnings enough to generate taxes, but it would maintain the accounting of the IRA's cost basis.

But I'm not aware of anything in the tax code or IRS rulings that explicitly requires you to zero-out the cost basis just because your balance went to $0. So I think my interpretation is correct. If I'm wrong, I'm going to start leaving a $1 in my account just to be sure. In fact I may start doing that anyway.

- Joel
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