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Trying to file taxes, I stumbled over a strange behavior of the software, and now I am wondering if this is actually the IRS regulation or just a bug.

Assume this situation:

  • On Jan/1 of 2016, X. has a Traditional IRA, consisting completely of Deductible Contributions from earlier years.
  • In March 2016, X. does a backdoor conversion of the complete Traditional IRA amount to a Roth IRA. X. expects the complete amount to be taxable income for the year 2016.
  • From April to August, the Traditional IRA has a balance of 0 (just to make this clear)
  • In September, X. makes a Non-Deductible Contribution of 6500 $ to the Traditional IRA. He understands that he needs to track this 'Basis' on form 8606.
  • The year ends with no further activities in those two accounts.

My assumption was that the complete conversion in March is fully taxable, and the 'new' money contributed in September is the new 'Basis' to be tracked (and its conversion next year should be tax-neutral).

However, the software assumes that the two amounts merge first, and then the rollover consists of the respective percentages of original deductible money and the new money, resulting in a lower tax payment, but also in a lower Basis for the next year.
I know that if you 'merge' contributions in the IRA account (even using different account with different providers), this would apply. However, I assumed that the clear separation of the activities by time - the IRA account was empty for months in between - would avoid this merging rule. How could money that comes in September 'merge' with money that is gone in March?

Which one is right?
Does the IRS require to merge the contributions, basically ignoring the sequence of activities within the year, considering all activity within the year happened at the same 'moment'?
Or is the software just not able to handle that correctly?

  • 2
    I want to note that what you did was not a "backdoor Roth IRA contribution". A backdoor Roth IRA contribution would be a (non-deductible) Traditional IRA contribution followed by a conversion of that amount to Roth IRA, resulting in no taxes, so it is has the same effect as a regular Roth IRA contribution. – user102008 Apr 5 '17 at 8:31
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I remember reading in an earlier version of Pub 590 (or possibly the Instructions for Form 8606) that timely contributions for Year X to an IRA are deemed to have been made on January 1 of Year X regardless of when they were actually made, but I don't seem to be able to find it now in current versions of Pubs 590a or 590b and so cannot include a citation of chapter and verse. Be that as it may, the calculations on on Form 8606 Part I effectively track basis on an annual basis rather than on a daily basis, and so the fact that the Traditional IRA has a zero balance (and basis 0 too) at some time during the year doesn't matter in the least. In detail (though you didn't ask for it)

  1. You report $6500 on Line 1 (Nondeductible contributions for 2016), 0 on Line 2 (Basis as of December 31, 2015), and a tentative basis of $6500 on Lines 3 and 5.
  2. You report the value of your IRA (say $6550) as of December 31, 2016 on Line 6, and the entire amount of the rollover to the Roth IRA (say $100,000) on Line 8, and the sum $106,550 on Line 9.
  3. Line 10 is Line 5/Line 9 = 6500/106550 = 0.061
  4. The nontaxable part of that $100K converted to a Roth IRA is $100,000x0.061 = $6100; you owe taxes on the rest
  5. That $6550 in your Traditional IRA as of December 31, 2016 has a basis of only $400, and not $6500 as you think it ought to be.

Note that the whole $6500 that you put in remains non-deductible in its entirety, but you owe taxes on only $93,900 of that $100K that you rolled over into a Roth IRA and not on the whole $100K as you were assuming would have been the case. So, in effect, of that $6500 nondeductible contribution to your Traditional IRA, you did really get to deduct $6100 from your taxable income for 2016, and make only a $400 nondeductible contribution, exactly equal to your basis in your Traditional IRA as per the Form 8606 calculations. I can only assume that the software package that you are using reproduces the above calculations exactly and does what the IRS says you must do on Form 8606 rather than what you get by tracking the basis on a daily basis.

IRS regulations and instructions are not necessarily the same as what the tax law says; they are interpretations of the tax law based on what the IRS understands the tax law to say. People have challenged various specific IRS regulations and interpretations as being different from what the law says in Tax Court and been successful in some cases and failed in others. If you believe that tracking basis on a daily basis is what the law says (instead of just being reasonable and rational: reasonableness and rationality are not required either of Congress in the laws that they write or the IRS regulations that interpret the laws), you should take up the matter with the IRS or the Tax Court.

  • @DilipSarwatem basically you are saying (same as the software says): "it doesn't matter that all the money was gone from the IRA before the new contribution, they still merge in the IRS' eyes?". I know how to do the calculations; my point was that I think they shouldn't be treated this way as the were never together. – Aganju Apr 3 '17 at 12:24
  • @Aganju OK, I have revised my answer to reflect your comment. – Dilip Sarwate Apr 3 '17 at 14:32
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    @Aganju: Yes, whether a contribution was made before or after the conversion makes no difference. Traditional IRA contributions for the whole year are considered for the purposes of the pro rata rule for a conversion made any time during that year. – user102008 Apr 5 '17 at 8:29

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