Mrs. ToKnow opened a retirement account in 1998 with $8,000 post-tax money. She’s been paying taxes on the dividends (when there were any). Last April, we decided to take advantage of the downturn to convert it to a Roth IRA so we could stop doing that second part, knowing we’d have to pay taxes on the dividends we’d earned since the end of 2019. But my preliminary run-through of our taxes make it look like we’re essentially on the hook for the entire value of the account.
What should I be looking at that I’m missing? We’re still trying to track down her copy of the 1998 tax return so we can prove she didn’t claim a deduction then, or if she did and has forgotten about it.
I’m confused about what happened here. I wonder if you might be too.
What kind of retirement account? If this was an IRA, I think the contribution amount was limited to $2,000 per year at the time. If this was some other kind of account, what kind of account was it?
If she opened an IRA or another kind of tax deferred retirement account, she should not have been paying taxes on the dividends each year. Was this a taxable account?
I’m going to guess a lot at what might have happened, what should have happened, what you should have done, an what might happen going forward.
I am guessing that you believe that in 2020, she converted a tax deferred account, such as an IRA or a 401(k), into a Roth IRA. If so, she would pay taxes on the entire amount of the conversion, less her basis in the account. She gets basis in the account when she makes an after-tax contribution. So, taking your story at face value, she should have reported to the IRS in 1998 that she made after tax contributions that gave her basis in the account. Did she do this correctly? Each year after, she should have reported on the 1040 any changes to the basis in the IRA account, that is for the most part, whether she made additional after-tax contributions…
On her 2020 return, she should be able to report the basis as part of the conversion, and she should not have to pay taxes on the amount of the already-taxed basis. She will pay taxes on the rest of the money, which is effectively treated like a taxable distribution from a retirement account. If she converted it to a Roth IRA it is not, however, subject to any penalty for early withdrawal.
I’m not sure how to fix this, to be honest, but I wonder if she will need to amend a prior year’s return to report that her account, in fact, had a basis that should not be taxed as part of the Roth IRA conversion.
This IRS publication has some instructions and discussion on reporting tax basis for after-tax contributions to an IRA. https://www.irs.gov/instructions/i8606
Thanks, that gave us some terms we didn’t have when we called Invesco. They looked back and it turns out that what she originally had was what they call a TOD account, which is essentially just a standard brokerage account that happens to have a named beneificary. So it was no kind of IRA at all, and never claimed to be. That was my error entirely; somewhat in my defense she has a separate account which is and always has been a Roth IRA, and I tend to think of these two accounts like Batman & Robin, just two parts of a whole.
So, at this point it looks like we tremendously overfunded her brand new Roth IRA account and are going to have to figure out how to adjust things before the deadline runs out (which I think is still April 15, but at this point I don’t know whether I trust myself any more). Looks like we’ll be getting some professional help soon.
Take a deep breath. This is a pretty easy one to fix. Since you made the contribution last year and you haven’t filed your tax return yet, all you need to do is remove the excess contribution and the earnings (if any) attributable to the excess. You are supposed to remove the excess contribution before you file your tax return, which is due April 15 this year.
I found a form online for removing an excess contribution from an Invesco account but you should contact Invesco and ask them which form to use. They will walk you through it and it shouldn’t be too hard. You also have to decide what to do with the extra money.