Making your retirement contributions tax efficient is one of the most important factors when planning your retirement strategy. Non-deductible contributions to an IRA may be part of that retirement plan. Workers under age 701/2 can deduct contributions to a traditional IRA, as long as they are not covered by an employer’s retirement plan. The same is true for those workers’ spouses.
If these taxpayers are covered by an employer plan, they may or may not be able to deduct IRA contributions, depending on the taxpayer’s income. However, all eligible workers and spouses can make nondeductible contributions to a traditional IRA, regardless of their level of income. Inside a traditional IRA, any investment growth of non-deductible contributions will not be subject to any further taxation. However, as shown in the examples below, calculating the taxable and non-taxable portions of IRA distributions can be complicated if your IRA holds a mix of deductible and non-deductible contributions.
Dealing with distributions
Problems can arise for people who hold nondeductible dollars in their IRAs when they take distributions. Unless they’re careful, they may pay tax twice on the same dollars.
Example 1: Marge Barnes has $100,000 in her traditional IRA on February 15, 2017. Over the years, she has made deductible and nondeductible contributions. Assume that $25,000 came from nondeductible contributions, $45,000 came from deductible contributions, and $30,000 came from investment earnings inside Marge’s IRA.
Now Marge wants to take a $20,000 distribution from her IRA. She might report $20,000 of taxable income from that distribution; indeed, Marge’s IRA custodian may report a $20,000 distribution to the IRS. However, Marge would be making a mistake, resulting in a tax overpayment.
Cream in the coffee
To the IRS, a taxpayer’s IRA money must be stirred together to include pre-tax and after-tax dollars. Any distribution is considered to be proportionate. If Marge were to pay tax on a full $20,000 distribution, she would effectively be paying tax twice on the after-tax dollars included in this distribution.
Example 2: After hearing about this rule, Marge calculates that her $25,000 of after-tax money (her nondeductible contributions) was 25% of her $100,000 IRA on the date of the distribution. Thus, 25% of the $20,000 ($5,000) represented after-tax dollars, so Marge reports the $15,000 remainder of the distribution as a taxable withdrawal of pre-tax dollars. Again, this would be incorrect.
Tax rules require an IRA’s after- tax contributions to be compared with the year-end IRA balance, plus distributions during the year, to calculate the ratio of pre-tax and after- tax dollars involved in a distribution.
Example 3: Assume that Marge’s IRA holds $90,000 on December 31, 2017. Her $100,000 IRA was reduced by the $20,000 distribution in February, but increased by subsequent contributions and investment earnings. Therefore, Marge’s IRA balance for this calculation is $110,000 (the $90,000 at year-end plus the $20,000 distribution). This assumes no other distributions in 2017.
Accordingly, Marge divides her $110,000 IRA balance into the $25,000 of after-tax money used in this example. The result—22.7%—is the portion of her distribution representing after-tax dollars. Of Marge’s $20,000 distribution, $4,540 (22.7%) is a tax- free return of after-tax dollars, and the balance ($15,460) is reported as taxable income. Marge reduces the after-tax dollars in her IRA by that $4,540, from $25,000 to $20,460, so the tax on future IRA distributions can be computed.
As you can see, paying the correct amount of tax on distributions from IRAs with after-tax dollars can be complicated. Without knowledge of the rules, an IRA owner may overpay tax by reporting already-taxed dollars as income. However, keeping track of after-tax and pre-tax dollars may not be simple, especially for taxpayers with multiple IRAs and multiple transactions during that year. Ultimately, it is up to the individual to track basis in their IRAs.
The best way to deal with this issue is to track pre-tax and after-tax IRA money by filing IRS Form 8606 with your federal income tax return each year that your IRA holds after-tax dollars. Our office can help prepare Form 8606 for you, when it’s indicated, and, thus, prevent this type of double taxation.