The step-transaction doctrine dates back to Gregory V. Helvering, a 1935 case which provides the basis of the substance over form tax doctrine. This holds that a tax court can take the substance of a transaction over its form, viewing several distinct transactions serving no independent legitimate business purpose besides to circumnavigate a tax law as a single disallowable transaction.
Generally, a single statement is sufficient, although some practitioners prefer to wait until the next tax year in order to perform the conversion. Adding non-deductible funds to an IRA then converting without waiting may result in a 6% over-contribution penalty per year.
Note: the current conversion and contribution reporting system of the IRS on Form 5498 and 8606 do not specify the timing of conversions and contributions, only the year, meaning the IRS has no effective way to track the exact timing outside of an audit. In spite of this, it is best practice to ensure that there is a reasonable timeframe between the contribution to the Traditional IRA and its conversion to a Roth IRA.
The pro-rata rule requires that the tax code aggregate all your IRAs, or treat them as one big IRA, for the purpose of calculating the taxable portion of distributions. If you have any pre-tax Traditional/SEPS/SIMPLE IRAs or any gains on IRA contributions that were non-deductible, then during a distribution or Roth conversion you must realize taxes on that distribution at the ratio of pre-tax and after-tax money in all of your IRA accounts as of December 31 of the tax year.
Thomas had $10,000 in an IRA which was made up of non-deductible contributions. He converts the non-deductible IRA into a Roth. He also had a separate IRA which is valued at $30,000 as of December 31. Due to the pro-rata rule, his $10,000 conversion was 75% taxable (1 - ($10,000 converted / $40,000 total balance)), resulting in $7,500 of additional taxable income.
Some individuals may have deductible and non-deductible IRA contributions in the same account. A 401(k) plan limitation may be of assistance in this scenario. 401K plans cannot accept non-deductible IRA funds, meaning one can instruct their IRA provider to perform a roll-in of only the pre-tax funds to a 401K plan, while leaving the non-deductible amounts untouched inside of an IRA, and available for conversion.
The five-year rule is an exception to one of the benefits of a Roth IRA which allows you to remove the principal at any time without penalty or taxation. Gains removed from the Roth prior to 59 ½ years of age will trigger taxation and penalties. If you were planning on moving money from a traditional IRA into a Roth so you can access it without penalty, be sure you wont need the money for at least 5 years.
End-of-Year Rollovers are rollovers from a workplace retirement plan to a traditional IRA which may occur after you perform a Roth conversion. IRA rollovers are common when switching jobs.
Thomas made a $6,000 non-deductible IRA contribution in January. In June, he converted that IRA to a Roth IRA. In November, he switched jobs and rolled his $30,000 pre-tax 401K into an IRA. Because Thomas had $30,000 pre-tax in a traditional IRA on December 31, he triggered the pro-rata rule, resulting in 83% of his conversion being taxable, adding $5,000 to his taxable income.
This tax bill could have been avoided had Thomas waited until the next year to roll out his 401K, or rolled it into a new 401K plan prior to December 31.
Need help with your Roth conversion? That’s what we’re here for. Speak with a Pattern advisor today.
Effective September 8th, 2022
This privacy policy (the “Privacy Policy”) discloses the privacy practices for Pattern Technologies Inc. and its affiliates (collectively, “Pattern,” “we,” “our,” and “us”) use the personal information we collect about you through our website, mobile application, and other online services (collectively, our “Services”) and when you otherwise engage with us. This Privacy Policy also describes how you can limit the personal information we collect about you. In this Privacy Policy, we use “customer” and “you” to refer to anyone who uses our Services.
By using our Services, you agree to this Privacy Policy. Your continued use of our Services after we revise this Privacy Policy means you accept any changes we make, so please check back periodically to our Privacy Policy for Updates.
Information Collection, Use and Sharing
We are the sole owners of the information collected on this site. We only have access to/collect information that you voluntarily give us via our mobile application, email, or other direct contact. We will not sell or rent this information to anyone. We will only use your personal information for the purpose for which it was collected.
Only employees who need your information to perform a specific job (for example, customer servicing) have access to personally identifiable information. We will use your information to respond to you, regarding the reason you contacted us.
We will not share your information with any third party outside of our organization, other than as necessary to fulfill a request you may have.
We may retain your personal information for the purpose of regulatory compliance. Our regulators require that we retain certain information about our customers for the purpose of documenting the quality and nature of advice we render, preventing money-laundering and the funding of terrorism, and fraud prevention.
Unless you ask us not to, we may contact you via email in the future to tell you about (for example) new products or services, or changes to this privacy policy.
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You can do the following by contacting us at team@patternfi.com
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This web site contains links to other sites. We are not responsible for the content or privacy practices of these other sites. We encourage you to be aware of when you leave our site and to read the privacy statements of any other site that collects personally identifiable information.
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We may anonymize and aggregate data such that it is not personally identifiable in order to better understand customer trends, strengthen security, and improve our services.
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Presently our services are only available to customers with a primary address in the United States, and who are US citizens or permanent residents.
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Some web providers have the ability to transmit “Do Not Track” (“DNT”) notifications. At this time we do not recognize DNT notifications.
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Our Advisory services are not intended to be used by children. If we become aware that we have collected data without legally valid parental consent from children under thirteen (13) years of age, we will take all reasonable steps to delete it as soon as possible.
Other Sites We May Share Information With
We will only share your information with those organizations necessary to complete your requests. Performing securities transactions requires the involvement of several parties including third-party identity verification vendors, an introducing broker/dealer, and a custodian.
Pattern leverages “Plaid” to connect your bank account with your brokerage account, verify bank account information, and confirm the balance in your account prior to initiating a transaction. Plaid maintains a separate privacy policy which can be found here: https://plaid.com/legal/#end-user-privacy-policy
Updates
Our Privacy Policy may change periodically and updates will be posted on this page. If you feel that we are not abiding by this privacy policy, you should contact us immediately at team@patternfi.com
