Isolating Basis for a Roth Conversion
By Kaye A. Thomas
Current as of April 17, 2014
If you’ve made after-tax contributions to a retirement account, you may benefit from isolating the basis in that account for a Roth conversion. The tax law creates obstacles to achieving this goal, but there are methods for overcoming them.
After-tax contributions to a traditional retirement account create basis, an amount that will be tax-free when distributed. When your account holds both pre-tax and after-tax dollars, the tax rules generally treat any distribution as a blend of the two, preventing you from taking a tax-free withdrawal consisting only of the after-tax dollars. The discussion here concerns methods that may make it possible to isolate basis so that after-tax dollars can be converted tax-free to a Roth account.
- This page provides an overview of the topic. An index to pages providing further details appears at the bottom of this page.
Basis and Roth conversions
A Roth conversion moves assets from an account in which investment earnings are tax-deferred to one in which they can be permanently tax-free. We have to weigh this benefit against the price of admission: income tax paid on the amount converted.
Depending on individual circumstances, the benefit may outweigh the cost even when the conversion is fully taxable. When a conversion includes after-tax dollars, the up-front cost applies to only part of the sum converted, while the benefit of eliminating tax on future investment earnings applies to the entire amount. The scales tip more and more in favor of a Roth conversion as the basis percentage increases.
The cost-benefit analysis for a conversion consisting only of after-tax dollars may appear to be simple. In this case the up-front tax cost is zero, while the benefit (tax-free future earnings) can be substantial. Achieving this result may require you to incur transaction costs, however. What’s more, the current state of the law creates uncertainty as to the tax consequences of some of the transactions described here.
- The IRS has indicated that guidance in this area may be forthcoming, but we have no clear indication of when that may occur.
Rules and techniques differ depending on whether you have basis in an IRA or in an employer plan such as a 401k.
Basis recovery from IRA
When you have basis in a traditional IRA, we divide the basis by the value of the IRA to determine the percentage of any distribution or conversion that escapes taxation. If you have more than one traditional IRA you have to aggregate them, using the total basis and total value rather than the figures for any one IRA.
Isolating IRA basis
A rule designed to improve the portability of retirement accounts creates an opportunity to isolate basis in an IRA. If you participate in a 401k or other employer plan that will accept a rollover from an IRA, you can roll just the pre-tax dollars. After that, you’re left with an IRA that holds only after-tax dollars, which can be converted to a Roth tax-free.
- The chief drawback to this technique is that it requires access to an employer plan that will accept a rollover from an IRA, so it isn’t available to everyone.
Basis recovery from employer plans
The rules for recovering basis from an employer plan are much friendlier. You don’t have to aggregate accounts if you participate in more than one plan. What’s more, it should be possible to have your after-tax contributions, together with their investment earnings, treated as a subaccount that you can withdraw or convert separately from other funds (pre-tax contributions, employer matching contributions, and earnings produced by these amounts). Employers aren’t required to offer this opportunity, however.
If you can convert this separate subaccount, and the ratio of investment earnings to basis is low enough, you may conclude that the tax cost is acceptable without taking any special measures to achieve a tax-free conversion. Basis isolation becomes more important when earnings represent a large fraction of this subaccount, or when the employer doesn’t offer the opportunity to withdraw (or convert) this subaccount separately.
Isolating 401k basis
Tax professionals have come up with a number of possible ways to isolate basis in an account in a 401k or other employer plan. Unfortunately the rules that apply to these transactions are not entirely clear. Experts — including the experts at the IRS — may disagree on the interpretation. Here are the possibilities we’ve identified:
- Direct conversion of after-tax dollars. We’re going to see that in most cases after-tax dollars are distributed pro rata with earnings generated by those dollars. Some have suggested that you can avoid that result — or the uglier one in the less common situations where after-tax dollars would come out pro rata with all other dollars, including pre-tax contributions — by designating the conversion as coming specifically from the after-tax dollars. This simple idea won’t fly with the IRS. We discuss it here only because initially some people thought it was viable.
- Isolate basis in IRA. Roll the employer account to a traditional IRA, and then use the IRA basis isolation technique described earlier. This is the most desirable approach, but it requires access to a 401k or other employer plan that will accept a rollover of pre-tax dollars from the traditional IRA, which may not be available.
- Split rollover methods. These approaches roll part of a distribution to a traditional IRA and the rest to a Roth. There are three variants, and no direct guidance from the IRS regarding any of them. The one that would be most difficult for the IRS to challenge requires the employer to withhold income tax against the pre-tax dollars, which may present a problem in completing the rollover.
It may be helpful to keep in mind the tax policies behind these rules.
- The technique that involves isolating basis in an IRA runs counter to the policy of requiring proportionate distributions of pre-tax and after-tax dollars from IRAs, but the opportunity is clearly available due to a rule that was created for a different purpose.
- Separate account treatment for after-tax contributions to 401k plans, together with their investment earnings, is not contrary to policy; it is precisely what Congress intended.
- Less clear is the policy concerning the technique in which you receive a distribution, roll part to a traditional IRA, and then roll the remainder to a Roth IRA. Congress clearly intended to make it possible to roll the pre-tax portion of a distribution to a traditional IRA and retain the after-tax portion free of tax. Arguably this implies that Congress intended to permit a tax-free conversion of the after-tax dollars, but the point is debatable.
It is perhaps understandable that the IRS has placed a low priority on offering further guidance that would serve as a roadmap for accomplishing a result Congress may not have intended.
Revision: It was called to our attention that an earlier version of the paragraph with the heading “Direct conversion of after-tax dollars” had been interpreted by some as indicating that distributions from a subaccount limited to after-tax dollars and their earnings was not permitted. Elsewhere in this guide we explain that this is possible, and we revised the above paragraph to clarify its meaning.
- Isolating Basis for a Roth Conversion
- Isolating IRA Basis
- Basis Recovery from Employer Plans
- Separate Subaccount Treatment
- Simple Payout
- Using an IRA to Isolate 401k Basis
- Split Rollover Methods