Keeping track of your non-deductible contributions made to one or more traditional Individual Retirement Arrangements (IRAs) can save you money when the time comes to withdraw from your accounts.
The basis of an IRA consists of the sum of nondeductible contributions minus any distributions of nondeductible contributions. When you take withdrawals, amounts that consist of basis are tax-free, which is good for your wallet. In contrast, withdrawn amounts that consist of deductible contributions and account earnings are fully taxable.
To ensure you get the most savings and avoid legal complications, file the correct tax form each year and maintain copies.
Calculating Tax-Free Basis
You need to file IRS Form 8606 (Nondeductible IRAs) with your income tax return for any year that you make non-deductible contributions to your traditional IRA. Then, when you take a withdrawal, you can figure out how much basis you have in your account by adding all the contributions reported on those Forms 8606.
If you have several traditional IRAs, calculate the total of any non-deductible contributions to all of your accounts. Then add up all the account balances and divide the total of the non-deductible contributions by the total balances to determine the percentage that consists of tax-free basis from non-deductible contributions. Use that percentage to figure out how much of each withdrawal consists of tax-free basis. The remaining amount of any withdrawal is taxable.
Example: You have two traditional IRAs. Over the years, you have made $15,000 of non-deductible contributions. On December 31, 2018, the combined balance of the accounts is $100,000, and you withdraw $20,000. Of the combined balance, 15% is from non-deductible contributions ($15,000 divided by $100,000). So you have $3,000 of basis in your $20,000 withdrawal (15% times $20,000). That amount is tax-free. The remaining $17,000 is taxable ($20,000 minus $3,000). But if you fail to keep track of your non-deductible contributions, you might mistakenly think the entire $20,000 is taxable.
A High-Wage Earner’s Tale in Court
In the late 1990s, a taxpayer established an IRA account with an investment management firm. He kept no tax or business records from that period, and he had only a vague recollection of relevant events. However, he credibly testified in Tax Court that he was a “high wage earner” during those years, and that he was therefore unable to claim a deduction for his initial contribution to the IRA.
From his testimony, the court inferred that the taxpayer was an active participant in a qualified retirement plan, and that the deductibility of his IRA contribution was therefore completely phased out due to his high income.
For the tax year in question, the taxpayer liquidated the IRA by withdrawing the entire balance of $27,745. The IRA trustee issued the taxpayer a Form 1099-R (Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.) that showed the withdrawal. The Form 1099-R indicated that a taxable amount was not determined. So it was up to the taxpayer to determine whether the entire $27,745 was taxable or not.
On his federal income tax return, the taxpayer did not report any of the $27,745 as income. Alerted by its computer document matching program, the IRS audited the taxpayer’s return and sent him a deficiency notice based on the assumption that the entire $27,745 was taxable. The unhappy taxpayer took his case to the Tax Court.
Although the taxpayer failed to produce any Forms 8606 to demonstrate that he had made a non-deductible contribution to establish the IRA, he did produce a 2006 account summary showing that the account was funded with an initial contribution of $4,760 sometime before 1998. Additional records showed that no other contributions were made to the IRA between 2007 and 2013.
The court ruled that this was sufficient evidence to conclude that the taxpayer had made a non-deductible contribution of $4,760 to establish the IRA. So the court determined that his taxable withdrawal was actually only $22,985 ($27,745 minus $4,760), instead of the $27,745 claimed by the IRS. (Shank, TC Memo. 2018-33)
The taxpayer would have won the day without having to go to court if he had maintained copies of his old return that included Form 8606 to support his non-deductible contribution.
Reach out to a tax professional to avoid complications. Utilizing a tax professional will ensure the correct forms are filed and maintained over the years.
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