We first posted on the topic of basis isolation for Roth conversions some four years ago, and we continue to receive inquiries on the topic. In response, we’ve upgraded our coverage. Previously we had a single article that described and critiqued the techniques that have been proposed. Now we offer a collection of seven articles dealing with different aspects of the topic.
After-tax contributions to a traditional retirement account, including an IRA, a 401k or a similar employer plan, create basis in the account. The portion of any distribution or Roth conversion representing basis is not taxable. A Roth conversion consisting only of after-tax dollars would result in zero taxable income, permitting you to move investments from a tax-deferred vehicle to one in which earnings may be entirely tax-free, without paying the usual cost of admission in the form of income tax on the conversion.
As a general rule, however, distributions and conversions from traditional retirement accounts that include both after-tax and pre-tax dollars will be treated as a blend of dollars from the two categories. The question becomes whether we can isolate the after-tax dollars so that they can be converted free of tax, without the need to convert any pre-tax (and therefore taxable) dollars.
Our new coverage of this topic does not include any recent guidance from the IRS, as they continue to maintain silence on the issue. We’ve added new research and insights, however. Most important is a new explanation of how the rules for basis recovery from 401k and similar plans permit partial isolation of basis without the need for any special techniques.
Full coverage: Isolating Basis for a Roth Conversion