Workers under age 70½ can deduct contributions to a traditional individual retirement account (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. However, all eligible workers and spouses can make non-deductible 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 non-deductible dollars in their IRAs when they take distributions. Unless they are careful, they may pay tax twice on the same dollars.
Example 1: Marge Barnes has $100,000 in her traditional IRA on February 15, 2017. Over the years, she has made deductible and non-deductible contributions. Assume that $25,000 came from non-deductible contributions, $45,000 came from deductible contributions, and $30,000 came from investment earnings inside Marge’s IRA.
Now Marge wants to take a $20,000 distribution from her IRA. She might report $20,000 of taxable income from that distribution; indeed, Marge’s IRA custodian may report a $20,000 distribution to the Internal Revenue Service (IRS). However, Marge would be making a mistake, resulting in a tax overpayment.
Cream in the coffee
To the IRS, a taxpayer’s IRA money must be stirred together to include pre-tax and after-tax dollars. Any distribution is considered to be proportionate. If Marge were to pay tax on a full $20,000 distribution, she would effectively be paying tax twice on the after-tax dollars included in this distribution.
Example 2: After hearing about this rule, Marge calculates that her $25,000 of after-tax money (her non-deductible contributions) was 25 percent of her $100,000 IRA on the date of the distribution. Thus, 25 percent of the $20,000 ($5,000) represented after-tax dollars, so Marge reports the $15,000 remainder of the distribution as a taxable withdrawal of pre-tax dollars. Again, this would be incorrect.
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 pre-tax and after-tax dollars 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 in February 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 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 result (22.7 percent) is the portion of her distribution representing after-tax dollars. Of Marge’s $20,000 distribution, $4,540 (22.7 percent) 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.
IRS Form 8606 (Form 8606)
As you can see, paying the correct amount of tax on distributions from IRAs with after-tax dollars can be complicated. Without knowledge of the rules, an IRA owner may overpay tax by reporting already-taxed dollars as income. However, keeping track of after-tax and pre-tax dollars may not be simple, especially for taxpayers with multiple IRAs and multiple transactions during that year.
The best way to deal with this issue is to track pre-tax and after-tax IRA money by filing Form 8606 with your federal income tax return each year that your IRA holds after-tax dollars. Our office can help prepare Form 8606 for you, when it is indicated, and, thus, prevent this type of double taxation.
Trusted Advice: Deducting IRA Contributions
- 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.