February Roth conversion taxable because of December rollover??

[Mike-E]

Here's what happened: On January 1st 2016, I had no money in any IRA account. I contributed $5,500 to an 2016 non-deductible IRA later in January and put it in a mutual fund. In February, I converted my entire IRA, now $5,400 to a Roth IRA. Because there were no gains, it should not be taxable. My IRA sat empty again. In December, I rolled over $10,000 from an ex-employer's 401k to my empty IRA. On 12/31/2016, my IRA balance was $10,000. Based on the IRA Distribution worksheet, it looks like I'm going to owe tax on my February conversion because there was a balance in my IRA on 12/31/2016. Am I reading it right? If so, no fair, IRS!

[dmertz · Accepted solution]

Yes, a large portion of your Roth conversion has become taxable as a result of the rollover of your 401(k) to an IRA. You've encountered one of the pitfalls of the "backdoor" Roth.  Instead of your entire basis being applied to the Roth conversion, only about $1,950 of your basis from your nondeductible traditional IRA contribution can be applied to your Roth conversion.  The other $3,550 of your basis remains in your traditional IRAs to be applied to later distributions or conversions in proportion to your overall traditional IRA balance.  The fact that your traditional IRA sat empty for a period of time in 2016 is entirely irrelevant to calculating the taxable amount of your conversion.