The question begins straightforwardly: what constitutes the basis in a rollover from a Roth 401(k) to a Roth IRA when the contribution amount surpasses the distribution due to an investment loss?

Finding the answer to this seemingly simple question is not as straightforward as it might seem. The authoritative guidance for this question is embedded within the Treasury Decision T.D. 9324, initially published in the Federal Register (a daily journal of the United States Government) on 04/30/2007, under document ID 72 FR 21103, which has been codified in the Code of Federal Regulations Part I, predominantly within 1.408A-10 (Coordination between designated Roth accounts and Roth IRAs), and 1.402A-1 (Designated Roth Accounts).

Let’s delve into the regulations. In response to the question:

For purposes of the ordering rules on distributions from Roth IRAs, what portion of a distribution from a rollover contribution from a designated Roth account is treated as contributions?

1.408A-10 (Coordination between designated Roth accounts and Roth IRAs) provides the following response in A-3(a):

(a) Under section 408A(d)(4), distributions from Roth IRAs are deemed to consist first of regular contributions, then of conversion contributions, and finally, of earnings. For purposes of section 408A(d)(4), the amount of a rollover contribution that is treated as a regular contribution is the portion of the distribution that is treated as investment in the contract under A–6 of §1.402A–1, and the remainder of the rollover contribution is treated as earnings. Thus, the entire amount of any qualified distribution from a designated Roth account that is rolled over into a Roth IRA is treated as a regular contribution to the Roth IRA. Accordingly, a subsequent distribution from the Roth IRA in the amount of that rollover contribution is not includible in gross income under the rules of A–8 of §1.408A–6.

These are quite a few words, but the crux lies in “the portion of the distribution that is treated as an investment”. This suggests that the cost basis can’t exceed the distribution, as a part can’t be greater than the whole. Typically, there are no issues. Problems only arise when an investment loss occurs, resulting in a situation where the contribution is more significant than the account value being distributed.

The sentence after “Thus” seems abrupt, as the sentence before it doesn’t appear to logically connect to the conclusion that follows. This is because this section refers to A-6 of Section 1.402A-1 (Designated Roth Accounts) to determine the “investment in the contract”. Though the circumstances are different, they bear some similarity, as it states:

(a) If a distribution from a designated Roth account is rolled over to another designated Roth account in a direct rollover, the amount of the rollover contribution allocated to investment in the contract in the recipient designated Roth account is the amount that would not have been includible in gross income (determined without regard to section 402(e)(4)) if the distribution had not been rolled over. Thus, if an amount that is a qualified distribution is rolled over, the entire amount of the rollover contribution is allocated to investment in the contract.

In simpler terms, this indicates that the amount not included in gross income should be treated as an investment. The insights gleaned from both sections, when read in conjunction, provide the understanding that in a qualified distribution, the entire amount of the rollover is not included in gross income, hence, it is treated as a regular contribution.

The next question that arises is how to determine what should be included and what should not be included in gross income, if it had not been a rollover? The answer to this question is provided in Section A-3 of 1.402A-1, which refers to section 72(e)(8):

(B) Allocation of amount received

For purposes of paragraph (2)(B), the amount allocated to the investment in the contract shall be the portion of the amount described in subparagraph (A) which bears the same ratio to such amount as the investment in the contract bears to the account balance. The determination under the preceding sentence shall be made as of the time of the distribution or at such other time as the Secretary may prescribe.

As the purpose of the allocation is to determine the tax-free portion of the distribution, consequently the ratio cannot exceed 1, a fact that is explicitly coded in the worksheet of the IRS pub 590-B (Distributions from Individual Retirement Arrangements), which also follows the same section 72 rule:

Worksheet 1-1. Figuring the Taxable Part of Your IRA Distribution

  1. Divide line 3 by line 6. Enter the result as a decimal (rounded to at least three places). If the result is 1.000 or more, enter 1.000

Before the implementation of the Tax Cuts and Jobs Act, losses from an IRA could be deductible, “but only when all amounts in all traditional IRA accounts had been completely distributed to you”, as stated in the 2017 version of Pub 590-B.

In a similar vein, if the cost basis exceeds the distribution, it is recognized only when the entire account balance is distributed. This is confirmed in 1.408A-10 (Coordination between designated Roth accounts and Roth IRAs) in A-3(b):

(b) If the entire account balance of a designated Roth account is distributed to an employee and only a portion of the distribution is rolled over to a Roth IRA within the 60-day period described in section 402(c)(3), and at the time of the distribution, the investment in the contract exceeds the balance in the designated Roth account, the portion of investment in the contract that exceeds the amount used to determine the taxable amount of the distribution is treated as a regular contribution for purposes of section 408A(d)(4).

The situation becomes more complex in this case because the rollover is indirect and only a portion of the distribution is rolled over to the Roth IRA. However, we can treat the direct and complete rollover as a special case within this clause. In simpler terms, if the entire account balance is distributed, the contribution amount that exceeds the distribution is treated as the cost basis.

Given that the section for the rollover to a Roth IRA mirrors that of the rollover to a designated Roth account, we can gain a better understanding of this treatment by examining the similar provision in 1.402A-1 (Designated Roth Accounts) A-6 for Roth IRA to Roth IRA rollover, where the situation is simpler as indirect rollovers are not permitted:

(b) If the entire account balance of a designated Roth account is rolled over to another designated Roth account in a direct rollover, and, at the time of the distribution, the investment in the contract exceeds the balance in the designated Roth account, the investment in the contract in the distributing plan is included in the investment in the contract of the recipient plan.

After thoroughly examining the relevant law, we can gain insights into the IRS instructions for forms 1099-R and 5498. As per the IRS instructions, on page 9, it stipulates:

If you are making a distribution from a designated Roth account, enter the gross distribution in box 1, the taxable portion of the distribution in box 2a, the basis included in the distributed amount in box 5 …

Notably, the phrase “the basis included in the distributed amount” implies that the basis cannot exceed the distribution.

Further on, page 13 states:

Box 5. Employee Contributions/Designated Roth Contributions or Insurance Premiums

Enter the employee’s contributions, designated Roth contributions, or insurance premiums that the employee may recover tax free this year (even if they exceed the box 1 amount).

This section, except the parenthetical clause intended for clarification, is quite straightforward. Despite its potential for confusion, it doesn’t provide incorrect information. It conveys two points: (a) Box 5 is for contributions that can be recovered tax-free, and (b) this amount could exceed the distribution. But when does (b) occur? The answer lies within the same page:

If a total distribution is made, the total employee contributions or insurance premiums available to be recovered tax free must be shown only in box 5. If any previous distributions were made, any amount recovered tax free in prior years must not appear in box 5.

The “Total distribution” checkbox on Form 1099-R indicates this scenario. Another potential situation could be a rollover of stocks in kind, wherein the cost basis travels with the stock. As the IRS instructions say on page 10:

If a distribution is a loss, do not enter a negative amount in this box. For example, if an employee’s 401(k) account balance, consisting solely of stock, is distributed but the value is less than the employee’s remaining after-tax contributions or designated Roth contributions, enter the value of the stock in box 1, leave box 2a blank, and enter the employee’s contributions or designated Roth contributions in box 5.

I genuinely question if anyone has ventured to read all of the preceding text. However, for the intrepid few who have, they’d likely concur that the tax code shares a striking resemblance with old company code — it’s riddled with such complexity that refactoring feels like an insurmountable task. The only viable solution involves establishing a brand-new tax system on Mars and gradually transitioning taxpayers to this neighboring planet.