Mental Accounting of Cost Basis on Roth Conversions

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RetiredCSProf
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Mental Accounting of Cost Basis on Roth Conversions

Post by RetiredCSProf »

I understand that cost basis is irrelevant for tax purposes on tax-favored accounts. I have created Roth accounts at Fido (brokerage account) and TRowe (mutual fund account) by converting from rollover IRAs. Fido and TRowe use different methods for tracking cost basis.

Which approach makes more sense for understanding the return on my investments? Or for understanding the benefit of the Roth conversion?

Fido tracks cost basis by the purchase price of the fund before it was converted, showing any income (cap gains or dividends) as having $0 cost. The price per share is averaged across the total number of shares I currently own. The cost basis increases if I purchase more shares or convert more (previously purchased) shares to Roth. If I sell shares, the cost basis decreases, with oldest shares removed first.

TRowe resets the cost basis to the value of the mutual fund at the end of the trading day on the Roth conversion. The value of cap gains is added to the cost basis, as if the shares were purchased on the day the gain was issued.

I know this is just mental accounting. The TRowe method helps me more in evaluating the success of my Roth conversion. But maybe Fido gives me a better picture of my overall ROI.
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retired@50
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Re: Mental Accounting of Cost Basis on Roth Conversions

Post by retired@50 »

I'm not sure I'm following your logic, but...

Maybe this will help: https://investor.vanguard.com/taxes/cos ... erformance

Regards,
If liberty means anything at all it means the right to tell people what they do not want to hear. -George Orwell
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RetiredCSProf
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Re: Mental Accounting of Cost Basis on Roth Conversions

Post by RetiredCSProf »

One difference is how TRowe and Fido handle cost basis of cap gains. The other difference is whether they reset cost basis on Roth conversion. For example, suppose that I purchase 100 shares each of funds Fido A and TR B in rollover IRAs at $10 per share each and convert both to Roth IRA at $15 per share each.

Assuming no cap gains on either fund, the cost basis of Fido A in the Fido Roth IRA account is shown as $1000, but the cost basis of TR B in the TRowe Roth IRA account as $1500. If both funds drop to $1200, the cost basis suggests that I am "ahead" in Fido A, but "falling behind" in TR B.
sycamore
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Re: Mental Accounting of Cost Basis on Roth Conversions

Post by sycamore »

RetiredCSProf wrote: Sun Jul 25, 2021 2:27 pm ...Which approach makes more sense for ... understanding the benefit of the Roth conversion?
The correct answer may be neither. My understanding is the bottom-line (of Roth conversion benefits) depends a great deal on tax rates over a period of time. E.g., if you end up in a lower tax bracket 10 years from now, then it would've been better to not convert.

RetiredCSProf wrote: Sun Jul 25, 2021 2:27 pm The TRowe method helps me more in evaluating the success of my Roth conversion.
Sorry, I don't quite follow. How exactly are you measuring success of a single conversion? If the current value of a share lot is more than when you did the conversion? Or something else?
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RetiredCSProf
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Re: Mental Accounting of Cost Basis on Roth Conversions

Post by RetiredCSProf »

Ideally, I want to convert funds that I expect to increase in value (post-conversion) to compensate for the "cost" of the conversion.

I am paying marginal rate of 24% federal and 9.3% state taxes (out of taxable funds) on conversions. I want growth in Roth (which I plan to leave as legacy) and slow growth in TDA (which will eventually start a slow decline as I approach my mid-80's, and RMDs surpass the gain).

I do not know if my tax rate will go up or down in the next ten years. My effective federal tax rate was increased by the Tax Reform Act of 2017; so, it is entirely possible that my effective federal tax rate will decrease if/when sunsetting of the remaining provisions of the Tax Reform Act.
Alan S.
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Re: Mental Accounting of Cost Basis on Roth Conversions

Post by Alan S. »

If you are primarily interested in tracking the long term results of a conversion, you should probably convert into a new Roth account. That way, no matter what investment changes occur later, the balance of that particular Roth can easily be compared to the amount you converted, the initial balance of the account.

Of course, the bottom line investment results is also affected by what this particular Roth account holding causes you to purchase in your other Roth accounts and the gain or loss in the other account.

You also need to track the conversion basis of all your Roth accounts for purposes of reporting any non qualified distributions under the Roth IRA ordering rules, but that tracking ends with the gross amount you converted, regardless of what happens with the investments purchased with the conversion funds. While you need to track your Roth basis (not referred to as "Cost basis") in all cases, this is not what you are asking about here. You are asking about investment results from converted money.

Brokers often show your cost basis of a Roth IRA (or a TIRA )investment just like they do in a taxable account, but this has no bearing on taxes due for any particular Roth distribution's tax reporting. It is only useful for tracking the gain or loss on a particular investment. In other words, this indicates whether you made a wise investment decision, and is totally unrelated to whether the conversion itself was wise. For the latter, you won't know until well into retirement.
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retired@50
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Re: Mental Accounting of Cost Basis on Roth Conversions

Post by retired@50 »

Delete.
Last edited by retired@50 on Mon Jul 26, 2021 12:38 pm, edited 1 time in total.
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FactualFran
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Re: Mental Accounting of Cost Basis on Roth Conversions

Post by FactualFran »

To determine the benefit of making a Roth contributions (regular or conversion), I keep track of the
  • amount of each Roth contribution
  • amount of income tax paid for each Roth contribution
  • balance of the Roth IRA
I calculate the benefit as

(balance - sum of contributions) / (sum of income tax paid) - 1

It took about 10 years for the benefit to become positive (the gain in the Roth IRA to be more than the income tax paid).

That calculation does not involve the cost basis as reported by Fidelity or T. Rowe Price.
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WoodSpinner
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Re: Mental Accounting of Cost Basis on Roth Conversions

Post by WoodSpinner »

RetiredCSProf wrote: Sun Jul 25, 2021 2:27 pm I understand that cost basis is irrelevant for tax purposes on tax-favored accounts. I have created Roth accounts at Fido (brokerage account) and TRowe (mutual fund account) by converting from rollover IRAs. Fido and TRowe use different methods for tracking cost basis.

Which approach makes more sense for understanding the return on my investments? Or for understanding the benefit of the Roth conversion?

Fido tracks cost basis by the purchase price of the fund before it was converted, showing any income (cap gains or dividends) as having $0 cost. The price per share is averaged across the total number of shares I currently own. The cost basis increases if I purchase more shares or convert more (previously purchased) shares to Roth. If I sell shares, the cost basis decreases, with oldest shares removed first.

TRowe resets the cost basis to the value of the mutual fund at the end of the trading day on the Roth conversion. The value of cap gains is added to the cost basis, as if the shares were purchased on the day the gain was issued.

I know this is just mental accounting. The TRowe method helps me more in evaluating the success of my Roth conversion. But maybe Fido gives me a better picture of my overall ROI.
Have you seen this thread?
viewtopic.php?t=354318

We may have a similar goal not quite sure.

WoodSpinner
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RetiredCSProf
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Re: Mental Accounting of Cost Basis on Roth Conversions

Post by RetiredCSProf »

WoodSpinner:

My goals are to answer these questions:
1) Does the calculated cost basis on Roth IRA provide any useful information, such as ROI or success of Roth conversions?
2) If cost basis provides some useful information for tax-favored accounts, which calculation method is most useful?

Thanks for the link to the related thread, which raises follow-up, broader questions:
3) What is a reasonable metric for measuring the success of a Roth conversion? (is it all about taxes and how/when money will be used?)
4) How much does asset location drive the measure of success in a Roth conversion?

I have some related "fine-tuning" questions, such as:
5) If I plan to convert a mutual fund to Roth in December, is it better to convert before cap gains are distributed?
6) Is a Roth IRA the best place to hold mutual funds that have distributed significant cap gains in the past?

Here are the numbers for my Fido Roth account:
Converted Amount: $150K
Fido Calculated Cost Basis: $170K
Current Balance: $380K

My Fido Roth account was funded only with conversions from the rollover Fido IRA -- none from contributions. All funds were converted "in kind," spread unevenly across 7 years, starting from 2015. No taxes were withdrawn on the conversions. Some funds were sold and reinvested after conversion; which reset the cost basis for that portion of the account to the purchase price of the new fund.
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