Tax question related to IRAs

Back in (I think) 1981, legislation was passed in the US that allowed most folks to contribute $2000 per year on a tax-deductible basis to an IRA account. Since Mr. Middon and I were fortunate to have enough disposable income, we did this every year.

Then in 1986(?) the law was changed so that this was not available to most folks – if your income was above a certain level and you were covered by an employer-sponsored plan, your contributions could no longer be deducted on your taxes. However, any income earned on your after-tax contributions would be tax-deferred. Since we wanted to save for our eventual retirements, we took advantage of this and kept making contributions.

Also, over the years we’ve had a couple of instances where upon changing jobs we received profit sharing or similar dollars. The contributions to these accounts were tax-deferred (as of course were the earnings on the account). These we rolled over into an IRA account.

In hindsight, we should have kept separate IRA accounts to reflect the source of the contributions, but somehow over the years accounts were combined (and then split into separate accounts for investment purposes – but that’s a separate issue).

So now I have an account that includes the following:

[li]Tax-deferred contributions made in the early days, which of course are taxable upon withdrawal,[/li][li]Income on those tax-deferred contributions (again, taxable),[/li][li]Rollover from an employer-sponsored tax-deferred account (taxable),[/li][li]Income on rollover (taxable),[/li][li]After tax contributions (not taxable), and[/li][li]Income on after-tax contributions (taxable).[/li][/ul]
At first, I thought I’d have to dig deep in our records and follow each contribution through as if the different types were kept in separate accounts. But then it occurred to me that if I could determine the total of contributions made on an after-tax basis, I could just prorate the account.

So, for example, say that I have $200,00 in my IRA, $40,000 of which is after-tax contributions. If I wish to withdraw $20,000 from that account, can I just tell the IRS that $4000 of that distribution reflects post-tax contributions, so $16,000 of my withdrawal is taxable? Or will they demand that I get down to the nitty-gritty of what happened with each contribution?

We received a form from the relevant financial institution each year for that year’s contribution. I imagine the IRS also got a copy of that form.

You are correct in your example, you only pay tax on a portion of each withdrawal. Your after tax contributions are called your basis. Each year you are supposed to report your basis, but as long as you can prove what it is, I don’t think it is a big problem. This form should explain things in more detail.

Each year that you make a non-deductible IRA contribution, you are supposed to file IRS Form 8606 with that year’s tax return. The form will show how much you made in non-deductible IRA contributions that year and the total number of non-deductible IRA contributions from your past years. The most recent Form 8606 thus will show the “total basis” in your IRA account from all of your after-tax contributions (Line 14).

I don’t know what you do if you made non-deductible contributions but failed to file Form 8606.

I found myself in this situation and also wished that my basis could be moved to a Roth IRA. Normally, you cannot do this but there is a workaround. To do this you need:

  1. A single IRA (with a mixture of pre and post-tax contributions)
  2. An employer 401k or 403b that will accept a rollover from the IRA.
  3. A Roth IRA

You then do a trustee-to-trustee rollover of the IRA, splitting the pre and post-tax dollars into the appropriate accounts. Since the value of your IRA will be zero at the end of the year, no taxes are due.

If you had tried to transfer just the $40k in the Roth, leaving $160k in the IRA - you would be taxed on $32k of the Roth transfer. Your basis in the $160k IRA would then be decreased by $8k
(I am not a tax expert, so talk to one before doing this, the regulations can change)