After-Tax Dollars in Traditional IRAs
By the AICPA
Workers under age 70½ 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. (See Trusted Advice below, “Deducting IRA Contributions.”) However, all eligible working taxpayers and spouses can make nondeductible contributions to a traditional IRA, regardless of income. Inside a traditional IRA, any investment earnings will be untaxed.
Dealing with distributions
Problems can arise for people who hold nondeductible dollars in their IRAs when they take distributions. Unless they have been diligent in tracking the after-tax (nondeductible) contributions, taxpayers may inadvertently pay tax twice on the same dollars.
Example 1: Marge Barnes has $100,000 in her traditional IRA on December 31, 2016. Over the years, she has made deductible and nondeductible contributions. Assume the $100,000 IRA balance is made up of:
1. $25,000 nondeductible contributions,
2. $45,000 deductible contributions, and
3. $30,000 investment earnings.
In 2017, Marge must begin minimum required distributions. Her financial advisor has calculated the required distribution from her IRA to be $20,000. At tax time 2018, Marge receives a form 1099R reporting the IRA distribution. Box 1 – Gross distribution will report $20,000. Box 2a Taxable amount might report $20,000 or the box may be blank with box 2b Taxable amount not determined checked. If Marge reports $20,000 of taxable income from that distribution, Marge would be making a mistake. The mistake would result in a tax overpayment because some portion of the $20,000 distribution is a nontaxable return of the $25,000 of the nondeductible contributions.
Aggregating All IRA Balances
To the IRS, a taxpayer’s IRA balances must be aggregated to include deductible and non-deductible contributions, as well as earnings. Any distribution from the IRA is considered to be proportionate to the contributions (deductible and nondeductible) and earnings.
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 nondeductible contributions, so Marge reports the $15,000 remainder of the distribution as a taxable income.
Guess what? Marge’s calculation is wrong again!
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 nondeductible contributions and deductible contributions 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 during the year, 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 balance 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 result¾22.7%¾is 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 nondeductible contributions can be complicated. Without full knowledge of the rules, an IRA owner may overpay tax by reporting already-taxed dollars as income. However, keeping track of nondeductible contribution dollars may not be simple, especially for taxpayers with multiple IRAs and multiple transactions during that year. The best way to manage the different types of contributions is to track IRA money by filing IRS Form 8606 with your federal income tax return each year.
Deducting IRA Contributions
The 2016 income limitation for deducting IRA contributions are as follows:
- Single filers who are covered by a retirement plan at work cannot deduct traditional IRA contributions for 2016 with modified adjusted gross income (MAGI) of $71,000 or more in 2016 ($72,000 for 2017 IRAs).
- On joint tax returns, covered workers are shut out from deductible IRA contributions with MAGI of $118,000 or more for 2016 ($119,000 for 2017).
- A spouse who is not covered by a retirement plan at work and files jointly with a covered worker can deduct IRA contributions as long as joint MAGI is less than $194,000 for 2016 ($196,000 for 2017).
- Other income limits apply to contributions to Roth IRAs in which contributions are never deductible, but future distributions may be tax-free.
The 2016 IRA maximum contributions are as follows:
The contribution is limited to the lesser of earned income or
- Taxpayers under 50 years of age: $5,500
- Taxpayers over 50 years of age: $6,500