Concerned about overpaying taxes on your IRA distributions? It's a valid worry but one that you can address if you have the right information. First, you need to know what kind of contributions you made—pre- or post-tax—and to what type of account. Keeping good records is key.
- Most contributions to an IRA are made with pre-tax money, meaning that the funds are not taxed until they are distributed or converted to a Roth IRA.
- After-tax contributions to an IRA, however, are not subject to tax upon distribution or conversion to a Roth IRA, as that tax has already been paid.
- In taking a distribution or making a conversion, you cannot designate that it is being done with after-tax money.
- Instead, you must figure the percentage of after-tax money in all of your IRA accounts and apply that percentage to the distribution, so you know how much of it is subject to tax.
Income Levels and IRAs
Contributions to a traditional IRA are supposed to be tax-deductible, but that’s not true for everyone. When you participate in a qualified retirement plan such as a 401(k) and have income above a threshold amount set annually for your filing status, the contributions you make to your traditional IRA are no longer deductible.
Of course, contributions to a Roth IRA are always made with post-tax income, if you qualify to make them, and distributions from a Roth IRA are always tax-free. Unfortunately, if you’re over certain income levels, you can’t have a Roth.
Even when IRA contributions are nondeductible, there are still good reasons to make them. They increase your retirement savings, and earnings on these contributions are tax-deferred. (Keep in mind that the annual contribution limit to an IRA is the same whether you make deductible contributions or nondeductible after-tax contributions.)
Traditional IRAs and Taxes
When you make tax-deductible contributions to an IRA, the funds in your account won’t be taxed until you take them out as a distribution or convert them to a Roth IRA. However, if your IRA was built in part with nondeductible contributions, you don’t owe tax on that money when it is distributed or converted, as it has already been taxed.
You might think that you could just say that the funds you distributed or converted came from the nontaxable money in your accounts, but the law doesn’t allow you to do that. Instead, you must compute the percentage of nontaxable funds in your accounts and then apply it to the amount of the distribution or conversion. You need to do this even if the IRA from which you are taking the distribution has only nondeductible contributions in it. This requires keeping good records of what you contributed to your IRA on an after-tax basis.
When you make a nondeductible IRA contribution, report it on Form 8606, Nondeductible IRAs. Enter any nondeductible contribution you make for the current year and add that to your nondeductible contributions in prior years (minus adjustments for distributions) to get the total basis across all your traditional IRAs. This information helps you to figure the tax on distributions and conversions. Be sure to retain copies of Form 8606, so you’ll have cost basis information for the future. Don’t assume that your IRA custodian or trustee will track this information for you.
Be sure to keep a running total of all your after-tax IRA contributions from year to year.
How to Figure Your Tax
When you have both types of traditional IRAs (those with tax-deductible contributions and those with after-tax ones), figuring out how much of your distribution or conversion is taxable is a complicated process. If the following explanation confuses you, it's worth getting the help of an accountant or another experienced tax preparer.
As noted above, you cannot designate that your traditional IRA distributions or conversions are coming solely from your after-tax contributions. Instead, you must figure out the percentage that nondeductible contributions account for in the total balance of all your accounts. Divide the total amount of your nondeductible contributions by the value of all your IRA accounts (including SEP IRAs and SIMPLE IRAs) as of the end of the year. Be sure to include in that value the distribution or conversion you are making as well as any others you've made during the year.
If, for example, you contributed $10,000 in after-tax money over the years to all of your IRAs and the balance in all of your accounts plus the distribution you are taking is $100,000 ($90,000 account balance plus a $10,000 distribution), your percentage would be 10% ($10,000 divided by $100,000). This percentage is the tax-free percentage of the IRA distribution. Multiply the distribution for the year ($10,000) by this percentage to determine what is tax-free ($1,000); the balance ($9,000) is taxable.
If you take a distribution before age 59½, you’re subject to a 10% penalty only on the taxable portion of the distribution (assuming no penalty exception applies). The 10% penalty does not apply to the tax-free portion of the distribution. In the case of the example above, you would pay a $900 penalty (10% of $9,000).
In Case of a Loss
If you have a loss on the investments in your account, you can recognize the loss, but only when all of the funds in your IRA have been distributed to you. The amount of the loss is the excess of the amount distributed minus any remaining basis from nondeductible contributions.
Let's say you made after-tax contributions to an IRA of $10,000 (assume no deductible contributions), and the account is now worth $4,000. If you fully distribute the funds, you have a $6,000 loss. The loss is taken as a miscellaneous itemized deduction on Schedule A of Form 1040 (you must itemize to get any tax benefit from the loss).
The Bottom Line
There are some good reasons to make nondeductible IRA contributions, but doing so complicates your tax life. Be sure to keep records so you won’t pay tax on these contributions when you take distributions or make Roth IRA conversions. And if math isn’t your strong suit, consider having a tax professional figure out what you owe.