23 Aug Pre-tax vs. after-tax IRA withdrawals

Q. Back in the 1980s when I was working, I contributed to an IRA with pre-tax and after-tax money. The after-tax total was $16,000. Now that I’m withdrawing money from my IRA, I have to fill out a special tax form every year to show how much of the distribution came from after-tax dollars. Is there a way to take the balance of the after-tax money in one shot and not mix it with my regular withdrawals?
— Tax form weary

A. First, here’s an IRA tidbit.

Most people think IRA stands for Individual Retirement Account, but it really stands for Individual Retirement Arrangement.

Anyway, there are three types of IRAs: traditional or deductible IRAs, nondeductible IRAs and Roth IRAs.

Given that you made your contributions in the 80s — before the 1997 birth of the Roth IRA — we can eliminate that type from the discussion.

“What you refer to as an IRA contribution made with after-tax money I am interpreting to be a nondeductible IRA,” said Neil Becourtney, a certified public accountant and tax partner with CohnReznick in Eatontown. “To make any IRA contribution, one must have earned income equal to or exceeding the IRA contribution.”

Becourtney said an individual can make a nondeductible IRA contribution when they are an active participant in an employer provided retirement plan (a box on Form W-2 is checked to indicate this) precluding a deductible IRA contribution based on the level of their modified adjusted gross income (AGI).

Using a single taxpayer for illustration purposes, Becourtney said, if modified AGI exceeded $71,000 for 2016 and the individual was a participant in an employer-provided retirement plan, then the taxpayer is prohibited from making a deductible IRA contribution.

Because no deduction is obtained when one makes a nondeductible IRA contribution, when one begins receiving IRA distributions a portion of the amounts withdrawn are nontaxable, he said. This is tracked on IRS Form 8606 – Nondeductible IRAs.

“Once a taxpayer makes any nondeductible IRA contribution, they need to file Form 8606 annually until they no longer have any IRA balances,” he said. “A taxpayer cannot choose to allocate their IRA distributions specifically against the tax basis created in previous years by the nondeductible contributions.”

Becourtney offered this example.

Let’s assume in your situation that as of Dec. 31, 2016, the value of all IRAs held by you totaled $100,000. The additional $84,000 above your $16,000 of nondeductible contributions reflects a combination of deductible contributions and investment growth.

“As your nondeductible contributions are 16 percent of the total IRA value, 16 percent or 16 cents of every dollar you may have withdrawn during 2016 is nontaxable,” he said. “If I further assume that you took a $4,000 IRA distribution during 2016, $640 would be nontaxable.”

Then you’d begin 2017 with a tax basis of $15,360 for your nondeductible IRA contributions.

This kind of calculation will need to be made each year, he said.

“If in 2017 you withdraw $20,000 from your IRA, you cannot apply the remaining $15,360 of basis against the 2017 distributions but rather this must be done proportionately,” he said.

Becourtney said it’s important to note this example pertains solely to the federal treatment. For New Jersey, a similar calculation is needed, however, the amounts may differ as New Jersey has never allowed a deduction for any IRA contributions.

It might be time for you to visit with a tax preparer.

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This post was originally published in August 2017.