May 9, 2024

Watch-outs For Your Roth Conversion

5 minute read
What You Need to Know Before Converting to a Roth

Roth conversions can result in a number of expensive pitfalls for the unsuspecting taxpayer. We’re covering several of the most common conversion mishaps below to keep you one step ahead. 

1. The step-transaction doctrine

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. 

TAKEAWAY: There should be some time between a non-deductible IRA contribution and its conversion into a Roth in order to clearly indicate they are separate legitimate transactions. 

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. 

2. The Pro-rata rule

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. 

TAKEAWAY: it is generally best practice to roll all of your pre-tax IRAs into a 401K or other non-IRA retirement plan prior to performing a Roth conversion. Failure to do so may result in double-taxation. 


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. 

3. The five-year rule

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. 

TAKEAWAY:  If you perform a conversion you must wait 5 years to remove the principal without penalty.

4. End-of-year Rollovers

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. 

TAKEAWAY: If you have converted IRA balances during the year, then any pre-tax IRA balances held on December 31 of that year will trigger the pro-rata rule as described above, even if they are moved into an IRA after the conversion takes place. 


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.

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