How do we figure out the taxation of this retirement account?


Q. My wife has a 457(b) account for which she had her first RMD in 2019. After the RMD, she executed a direct rollover of a portion of the funds remaining in the account to a traditional IRA during the same year. Because contributions to the 457 plan were federal pre-tax but state after-tax, a New Jersey basis exists and equals the total of the contributions. Therefore, distributions for state tax purposes must return a portion of the basis tax-free, and rollovers to another plan or to a traditional IRA must transfer the N.J. basis into that plan or IRA. What methodology applies for determining the size of the basis for distributions and direct rollovers into a traditional IRA?
— Prepping for tax time

A. You are correct in your assertions.

Because your wife has already been taxed on contributions by New Jersey, you must determine which portion of your distribution is taxable and which is excludable, said Laurie Wolfe, a certified financial planner and certified public accountant with Lassus Wherley, a subsidiary of Peapack-Gladstone Bank, in New Providence.

She said for pension plan distributions, there are two methods of calculating the taxable and excludable amounts: the Three-Year Rule Method and the General Rule Method.

This determination is made in the first year that you have to take an RMD, which in your wife’s case was 2019.

The Three-Year Rule Method is used if you will recover all your contributions within 36 months from the date you receive your first payment from the plan, and both you and your employer contributed to the plan, Wolfe said.

“Total the amount of pension payments that you will receive in the first 36 months. If this amount is greater than your basis, then you can use this method,” she said. You should exclude payments received from income until the payments received equal the amount you contributed to the plan.”

This will not necessarily be a full 36 months, she said. Report the amount you exclude on line 20b of the New Jersey tax return. After you have excluded all of the basis, your payments are fully taxable, she said.

The second method is the General Rule Method.

You must use this method if you will not recover your contributions within 36 months from the date you receive your first payment from the plan or if your employer did not contribute to the plan, she said.

Part of your pension is excludable and part is taxable every year, Wolfe said. The excludable amount represents your contributions.

“The methodology for this rule is to prorate the basis,” she said. “A percentage is determined by dividing the basis by the total expected return on the contract. That percentage is applied to the payments received in the year to determine the amount excludable.”

For your wife’s first withdrawal, you will use the above to determine taxability.

Because she then rolled over the account into an IRA, different rules will apply in the years that follow, Wolfe said.

“Beginning in 2020 she will complete Worksheet 3 in the instructions to the New Jersey tax return NJ-1040,” she said. “If you have multiple IRAs, you can either complete a separate worksheet for each one or combine them all together.”

She said the worksheet walks you through computing the amount of remaining basis each year and dividing that by the sum of the value of the IRA at year end plus total distributions for the year. The resulting percentage is applied to the total distributions to determine the amount that is not taxable, she said.

This worksheet must be completed each year.

“Your wife rolled this account over in 2019, therefore year-end values are reported in the same manner as any other IRA,” she said. “Form 5498 will report the year-end value and also the amount of the rollover made into the account.”

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This story was originally published on March 20, 2020. presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.