Income Tax Guide Click Here
If you're a retiree taking distributions from your IRA, you might assume that all of this income is taxable. But wait. Are there any after-tax contributions in the account? These are funds on which you paid tax when you made the investment and, as a result, can now be withdrawn tax-free. Although there are special rules to follow when you take these distributions, and you'll have to fill out another tax form, the effort could put some extra dollars in your pocket. We'll give you the details on what types of contributions might be non-deductible and how to determine whether some of your IRA distributions could be tax-free.

First, though, you might wonder how anyone could even have non-deductible contributions in an IRA account. After all, isn't the tax deduction one of the big benefits of investing in an IRA?

How After-Tax Money Could Land in your IRA
Getting a tax break each year is certainly one reason to open an IRA. Despite this, however, there are several circumstances that could result in non-deductible money ending up in your account. And if you've already paid tax on that money, you can withdraw it without having to do so again.

Advertisement - Article continues below.

For example, perhaps there were years when you made the maximum contribution to your IRA and were covered by a retirement plan at work. If your modified adjusted gross income exceeded the allowable limits, all or some of your contributions could have been non-deductible. You should have reported this on Form 8606. (To learn more, see IRA Contributions: Deductions And Tax Limits and Traditional IRA Deductibility Limits.)

Another common way non-deductible money gets into an IRA is from retirement plans. Have you ever rolled over funds from a previous employer's retirement plan into your IRA? Company-sponsored plans often allow pre-tax and after-tax contributions. If you made after-tax contributions, there's a possibility that you may have already paid tax on some of those dollars and, therefore, you can avoid paying tax on that money again. (For more insight, read Rollovers Of After-Tax Assets May Change The Landscape Of Your IRA and Rolling Over Company Stock: A Decision To Think Twice About.)

Finally, there's always the possibility that you inherited an IRA from someone who had non-deductible contributions in his or her account. (See Inherited Retirement Plan Assets - Part 1 and Part 2.) As in the above examples, because this is after-tax money, you are not required to pay taxes on it a second time.

How to Handle Distributions
If it turns out that there are non-deductible contributions in any of your Traditional IRAs, you have a cost basis in those funds. This is a good thing because it means that because they are a return on your investment, they are not taxed when they are distributed to you. Don't get too excited just yet, though. You can’t just assume that the initial withdrawals are tax-free up to the amount of the basis, even if you only made a few non-deductible contributions over the years. In other words, only the part of the distribution that represents non-deductible contributions (your cost basis) is tax-free. (To learn more, read How do I figure out the cost basis on a stock investment?)

The distributions will consist of non-deductible contributions (the cost basis) and deductible contributions, earnings, and gains (if there are any). Therefore, each distribution is partly nontaxable and partly taxable. To calculate this, add the total of your non-deductible IRA contributions and any after-tax money rolled in from retirement plans, then divide that sum by the total amount of money in all of your IRAs at the end of the year. The result is the percentage of the distribution that's tax-free. You'll continue to go through the same exercise each year until your cost basis has been removed.

You must report this pro-rata distribution on Form 8606 and attach it to your return. If you are not required to file an income tax return, you are still required to file Form 8606.

If you inherited a Traditional IRA from a person who had a basis in the IRA because of non-deductible contributions, that basis remains with the account. Unless you are the decedent's spouse and choose to treat the IRA as your own, you cannot combine this basis with any basis you have in your own Traditional IRA(s) or those you may have inherited from other decedents. If you take distributions from both an inherited IRA and an IRA of your own and each has basis, you must complete separate 8606 forms to determine the taxable and nontaxable portions of those distributions.

What if you've inherited an IRA and you don't know whether the deceased made non-deductible IRA contributions? You will have to locate Form 8606, which would be attached to past tax returns. If you can't find any copies of Form 8606, this does not necessarily mean that there weren't any non-deductible contributions made, as it is possible that they just weren't filed. If this is the case, check IRA statements or find Form 5498, which shows whether IRA contributions were made. You can then refer to the tax return to see whether a deduction was taken. If it wasn't, you can probably assume that the contribution was non-deductible.

Before You Roll Over Your Retirement Plan
When you have non-deductible contributions in your former employer's retirement plan, think about how soon you might need that money before you roll it into your IRA. You can remove these contributions from the plan tax-free before rolling the money over, although other penalties could apply. (See Tough Times … Should You Disturb Your Qualified Plan’s Assets?)If you want to have access to those funds in just a year or two, you might be better off taking them out before the rollover. Then you could roll the balance of the plan's assets (before-tax contributions and all earnings) into your IRA where they will continue to grow tax-deferred. Otherwise, if you combine all of the funds within the rollover, you will have to use the pro-rata rule when you take any money from your IRA. (To read more, check out Can I transfer non-deductible Traditional IRA contributions to my Roth without being taxed?)

A final option
If you find that you have non-deductible contributions in your IRA, you might want to consider a Roth IRA conversion (assuming that you otherwise qualify for the conversion). If you choose this option, the non-deductible contributions will be transfered tax-free to the Roth IRA, and you will have to pay tax on the untaxed contributions and all the earnings they produced. Once you have met the IRS requirements, all withdrawals from the new Roth will be tax-free.

For further reading, see Did Your Roth IRA Conversion Pass Or Fail and Tax Treatment Of Roth IRA Distributions.
Income Tax Guide Click Here