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How does a loss when someone does a conversion from a traditional IRA to a Roth IRA get accounted for? Is there a loss carry over to future years to offset future gains from conversions?

Thank you, Ken
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Losses and gains are not applicable for IRAs.
Taxes are paid at income rates upon distribution from a traditional IRA (including conversions which are treated for tax purposes as distributions to your Roth).
No taxes are paid on Roth distributions.
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How does a loss when someone does a conversion from a traditional IRA to a Roth IRA get accounted for?

It doesn't. All distributions from a Traditional IRA, whether they are used to do a conversion or not, are taxed at ordinary income rates. Whether you had a gain or a loss within the Traditional IRA doesn't matter - it's the value of what you are taking out on the date of the distribution.

It used to be that if you did a conversion, and then suffered a loss in the Roth after the conversion, you could do a recharacterization to move the money back to the Traditional IRA, wait a year (I think) and then do another conversion. But since the TCJA eliminated recharacterizations of Roth conversions, that option is no longer available.

Is there a loss carry over to future years to offset future gains from conversions?

No.

AJ
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aj485,

I have a follow-on question for you and the rest of the board. Let me pose it as a scenario:

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) Then something happens to the market and my shares of IVV are now worth $4,000. Now I do a Roth IRA conversion and the value of my conversion is only $4,000.

Now in year #2 I make a similar $5,000 non-deductible Traditional IRA contribution. Again I invest in IVV and the market goes up instead. When I do the Roth IRA conversion, I convert $6,000.

Do I have a $1,000 taxable event?

As I understand this scenario after the conversion in year #1 the traditional IRA retains a $1,000 cost basis from the first contribution after $4,000 has been converted to the Roth IRA. After the $5,000 contribution in year #2, the traditional IRA now has a cost basis of $6,000. This should mean the conversion in year #2 is effectively tax-free.

So what's the correct answer? Did I have a taxable event in year #2 or not?

- Joel
PS: I think the correct answer is No.
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Joel:

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

In your example, let’s say year 2 was a gain of $400. Does the other $600 get carried over to future years?
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PS: I think the correct answer is No.

I would have thought it's "Yes".

Because how can you have a basis in a non-deduc. IRA when the balance is $0?

BUT I am looking at form 8606 and it seems that the answer is no... But I'm not a tax professional.
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Ken288,

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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How does a loss when someone does a conversion from a traditional IRA to a Roth IRA get accounted for?

ROTH loses are only deductible when all ROTHs IRAs are closed. It would also mean that the total value of the ROTH is less than the contributions.
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Joel,

Your examples assume that you have not other TIRA. The cost basis is prorated across all TIRAs and not just the specific TIRA involved in the conversion.
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IRA losses when closing all of a specific type were a miscellaneous deduction. I believe, this type of deduction was eliminated with the most recent tax law changes.
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I think aj485 probably understood this was implied.

Actually, no I didn't. Because there wasn't anything mentioned about basis or non-deductible contributions, my initial answer was based on converting a Traditional IRA without any basis, since that's the more typical case.

For an account with basis, as vkg indicated, it used to be if you distributed the entire balance of a Traditional IRA and still had basis that hadn't been used up, the loss would be deducted as a miscellaneous deduction, subject to the 2% of AGI rule. From the 2017 590-B https://www.irs.gov/pub/irs-prior/p590b--2017.pdf

Recognizing Losses on Traditional IRA Investments
If you have a loss on your traditional IRA investment, you can recognize (include) the loss on your income tax return, but only when all the amounts in all your traditional IRA accounts have been distributed to you and the total distributions are less than your unrecovered basis, if any. Your basis is the total amount of the nondeductible contributions in your traditional IRAs. You claim the loss as a miscellaneous itemized deduction, subject to the 2%-of-adjusted-gross-income limit that applies to certain miscellaneous itemized deductions on Schedule A (Form 1040). Any such losses are added back to taxable income for purposes of calculating the alternative minimum tax.


However, the TCJA eliminated miscellaneous deductions, so there is no longer a provision to deduct the loss. That said, I don't know that there was ever any provision to 'carry over' or 'retain' the basis when your account balance is $0. And I'm not sure I would like to be the test case when the IRS argues that an account balance of $0 can't have a 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.

I think that you may very well be incorrect. Given that there was specifically a provision to deduct the loss, I think that the absence of any direction of how to carry over a loss with a $0 account balance means that the IRS hasn't established a way to do so. That's kind of confirmed by the fact that the section on 'Recognizing losses on Traditional IRA Investments' has been removed and not replaced in the 2018 Pub 590-B https://www.irs.gov/pub/irs-pdf/p590b.pdf And as I said, I'm not sure that I would want to be the test case.

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.

I would actually suggest leaving more than $1 in the account - probably something closer to the amount of the loss you are trying to preserve, assuming there's at least that much left in your account. If there isn't that much left in your account, I would suggest not doing a conversion that year.

AJ
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aj485,

You wrote, I would actually suggest leaving more than $1 in the account - probably something closer to the amount of the loss you are trying to preserve, assuming there's at least that much left in your account. If there isn't that much left in your account, I would suggest not doing a conversion that year.

It's never possible to leave exactly what you lost in the account. If you have a $1,000 loss and want to leave a $1 in the account, your cost basis is $1,001. If you leave $1,000 in the account with a $1,000 loss you have a $2,000 cost basis. Your cost basis is always by definition what you have in the account plus your accumulated losses … so I'm not sure what good trying to leave some larger amount in the account really does for you.

But I do take the point that if the IRS previously permitted the losses to be treated as an itemized deduction subject to the 2% limit and then subsequently eliminated the option to itemize deductions I might have a problem if I ever dropped the balance to $0 while retaining a loss.

With that said, I've only been making non-deductible contributions for the past 3 years and I've only converted twice. Each time I closed the TIRA. (First time on purpose; second by accident.) However in both cases I had a small taxable portion to convert so I've not yet had a to deal with this scenario in practice. In the future I'll keep an eye out for this situation. Or I might always just leave $1...

- Joel
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It's never possible to leave exactly what you lost in the account. If you have a $1,000 loss and want to leave a $1 in the account, your cost basis is $1,001. If you leave $1,000 in the account with a $1,000 loss you have a $2,000 cost basis. Your cost basis is always by definition what you have in the account plus your accumulated losses … so I'm not sure what good trying to leave some larger amount in the account really does for you.

When I said 'something closer to the amount of the loss you are trying to preserve' I was trying to suggest an amount that might show a 50% or 75% loss from the basis that was left, rather than a 999% loss. My concern would be that the IRS may view having a $1001 basis on just $1 left in the account as trying to go around the rules. If you had a $2000 basis with $1000 or a $1500 basis with $500 left in the account, it would be less likely to draw scrutiny from the IRS, IMO.

Yes, technically, leaving $1 in the account with a $1001 basis is within the rules. But you might end up having to spend money on lawyers and accountants to be a test case with that, too.

AJ
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